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Are Small Cap Funds meant for you? - Outside View by PersonalFN
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Are Small Cap Funds meant for you?
Apr 28, 2011

Today everyone seems to be a in a race of making quick money in the Indian equity markets. Thanks to the Euphoria and the buzz created by all the business channels and the pink papers, who give all sorts of day trading and short-term recommendations to investors. And very often to add to this excitement of momentum playing your brokers also push you some small cap bets, which you often believe are flying machines for wealth creation. We all invest in the equity markets to make to money - to generate wealth; but merely going what your broker says and riding on the momentum stocks can be hazardous to your wealth as well as health.

Remember, in your objective of making quick money in the equity markets (by providing short-term trading recommendations in the small cap space) your broker does not take any onus of erosion of your wealth.Instead he just pacifies you by merely giving you wrong hopes of an upside movement in the respective small cap stock. And very often these wrong hopes are based on some mendacious insider information germinating in the market place.

Interestingly cashing on your upbeat emotions for quick money through a fancy for investments in the small cap segment, many mutual fund houses too have aggressively launch small cap funds during the Euphoria of the equity markets. Presentations made during the fund management meetings look very appealing which often tempts you to invest in "small cap funds", but the question still remains - "Are small cap funds really meant for you?"

Today there are 6 small cap funds, (dominantly focusing on the small cap segment) but interestingly if you observe the table below, all of them were launched during the Euphoria of the equity markets in 2007, early 2008 and 2010 (when the markets again recovered from the U.S. sub-prime mortgage crisis).

Making hay when the sun shines
Name of the equity oriented Small Cap fund NFO open Date NFO Close Date Inception Date
DSP Micro-Cap Fund 04-May-2007 25-May-2007 20-Jun-2007
JP Morgan India Smaller Cos Fund 09-Nov-2007 30-Nov-2007 27-Dec-2007
L&T Small CapFund 20-Nov-2007 20-Dec-2007 10-Jan-2008
HSBC Small Cap Fund 19-Jan-2008 03-Mar-2008 31-Mar-2008
IDFC Small & Midcap Equity Fund 09-Jan-2008 15-Feb-2008 07-Mar-2008
Reliance Small Cap Fund 26-Aug-2010 09-Sep-2010 21-Sep-2010
(Source: ACE MF, PersonalFN Research)

Moreover, respective mutual fund houses launched their small fund in sheer competition one after the other, with an objective to garner more AUM (Assets Under Management) and made hay when the sun shined.

But all you investors, who got carried away with the enticing advertising campaigns, marketing presentations and not to forget the euphoria; did you really benefit -did you really create wealth?

Report Card
Scheme Name 6-Mth (%) 1-Yr (%) 2-Yr (%) 3-Yr (%) Since Inception (%) Std. Dev (%) Sharpe Ratio Portfolio Turnover Ratio (%) Expense Ratio (%) AUM* (Rs. in Cr.)
IDFC Small & Midcap Equity (G) -8.3 9.8 52.2 23.6 22.1 5.1 0.3 324.0 2.1 1,108
DSPBR Micro-Cap (G) -13.2 11.1 70.7 15.0 12.6 9.3 -0.2 142.0 2.3 438
HSBC Small Cap (G) -21.3 3.4 50.3 5.2 5.6 10.5 -0.2 75.0 2.5 39
JP Morgan India Smaller Cos (G) -8.9 10.4 53.5 2.6 -7.2 11.1 0.1 93.0 2.4 179
L&T Small Cap (G) -17.9 -16.1 29.8 -8.4 -18.6 11.5 0.0 58.0 2.5 17
Reliance Small Cap (G) -1.3 - - - -0.9 4.1 -0.4 - 2.2 532
BSE SMALLCAP -16.6 -3.2 52.7 3.4 - 13.5 0.1 - - -
BSE SENSEX -3.9 8.5 34.2 7.2 - 9.7 0.1 - - -
(NAV data is as on April9, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period.
Risk-free rate is assumed to be 6.37%)
*AUM as on March 31, 2010
(Source: ACE MF, PersonalFN Research)

Well, the table above reveals that not all small cap funds have delivered appealing returns. Over a 3-Yr time frame and since inception barring two (i.e. IDFC Small & Midcap Fund and DSPBR Micro-cap Fund) all of them have disappointed their investors on the returns front. Even those who delivered appealing CAGR (Compounded Average Growth Rate), have been able to do so after immense churning in the portfolio (IDFC Small & Midcap Fund 324%, while DSPBR Micro-cap 142%), which in turn has added cost for you investors. This is because every time the fund churns its portfolio, it pays for brokerage and other transaction charges which make the expense ratio of the fund rather heavy.

Even on the risk-return front most of them have been high risk-low return investment propositions, and you may be wondering why so?

As seen earlier most of these small cap funds were launched during euphoria of the equity markets (in 2007 and early 2008), when stock prices within this segment were already elevated. Hence when the fund manager undertook their stock picking activity, they bought small cap stocks at expensive valuations, but didn't get the further upside movement since the U.S. sub-prime mortgage crisis emerged in severity and hammered these small cap stocks which were once thought to be flying machines for wealth creation.

Performance across Market Cycles
Schemes / Index Bull
20-March-07 to 09-Jan-08
Bear
09-Jan-08 to 09-Mar-09
Bull
09-Mar-09 to 09-April-11
Small cap funds* 31.4 -59.4 52.5
BSE Smallcap Index 151.0 -73.4 71.1
BSE Sensex 84.8 -55.4 51.8
*Note: Average returns have been calculated of the peers above
(Source: ACE MF, PersonalFN Research)

The table also evidences the fact that small cap funds have not been able to sail well during the turbulence of equity markets. In fact most of them even during the bull phase of the Indian equity markets have lagged the returns of BSE Small Cap Index as well as the BSE Sensex. Moreover a noteworthy peculiarity has been that they have plunged more during the downside of the Indian equity markets, thus exposing you to times of wealth erosion rather than wealth creation.

The portfolio analysis of small cap funds reveals that they take bets in small cap stocks which tend to be quite violent during various sentiments of the equity markets. But then you may be wondering - what makes the fund manager bet on such stocks, if they are so risky?

Well, it's the fund management team's expectation (driven by some research) that the small companies would blossom into tomorrow's mid caps which induces to buy them. But the fact is very often the fund managers lack conviction over a period of time and indulge in momentum playing (as revealed by their high portfolio turnover ratio), which makes them (fund managers) look like traders rather than investors in these companies.

For some funds which have a low portfolio turnover ratio, but unappealing returns to display, it possibly reflects the case of fund managers stock bets having gone wrong and where he finds it difficult to exit from the fund (as the fund would have to suffer).

It is noteworthy that liquidity is also generally a constrain in most of the small cap stocks, but if the mutual fund house follows strong investment process and systems, then that's taken care of, since the process itself will eliminate stocks which have proved to be illiquid in the past.

Acute redemption pressures is also what small cap funds have to succumb to especially during times when the equity markets turns turbulent and investors press the panic button. This in turn leads to the NAV (Net Asset Value) of the funds dropping sharply and causing immense volatility to the fund.

Hence remember while the exuberance created in the market may sound all good and create a rosy picture of the small cap segment, you should assess these critical features of small cap funds, assess your risk taking ability and then invest in small cap funds.

In our opinion we strongly affirm that you investors should refrain from investing in pure small cap funds, as identifying stocks within the small cap segment is generally not an easy task for respective fund management teams. Moreover small cap companies face host of problems such as:
  • Lack of capital

  • Higher debt-equity ratio

  • Lower interest coverage ratio

  • Poor liaison

  • Labour problems
Remember, a good mid cap fund, or even a well diversified multi-cap fund or flexi-cap fund can also enable you to achieve your objective of wealth creation by adding a dash of robust small cap stocks to your portfolio.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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