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When Funds Don't Make Sense

When it comes to small-caps, investors might be better off investing in stocks

I've always said that most people are better off investing in equities through mutual funds than directly. The advantages of getting professional investment management without having to deal with researching stocks and trading and tracking a portfolio full of stocks is too much of an advantage to give up.

However, investing in small-cap companies may be an exception to this. There are some peculiarities to small-cap investing that don't combine very well with the way mutual funds have to be managed. Let's look at the numbers. There are 62 funds in Value Research's Mid and Small Cap category. Of these, no more than six are either exclusively or primarily focused on small-cap stocks.

These funds have had a patchy performance with a large amount of volatility and have been unable to give attractive returns even over relatively long periods of time. Of course, volatility is a given in any small cap portfolio. Smaller companies tend to react violently to any change of mood. However, the whole idea is that the investment manager will eventually be able to build a decent base of investments in a set of small-cap companies that are on their way to growing out of the category and into being mid-cap companies.

Here lies the problem. If a knowledgeable and expert investor were to do this directly, he would probably identify a handful of companies and then would slowly build positions in them. This would have to be done slowly because by definition, these companies have low capitalisation and are thus likely to have low trading volumes and probably low floating stock as well. This, in turn, means that the impact cost of trying to buy a large chunk of stock too quickly could be quite high.

The investor would have to understand that the same rules apply if he wants to exit the stock in a hurry. These stocks are not liquid, and when the time comes to realize your returns, you could again have to wait for a long time to encash your investments. Just as you did when buying into the stock, the selling would also have to be done in dribs and drabs. If that isn't done then again, the impact cost of selling to much stock too quickly would itself depress the price.

This is particularly true when markets take a sharp turn downwards. In such situations, many small-caps are not sellable at all. What this means is that the investor must be truly convinced by a small cap stock to hold it through a trough and (hopefully) to a later peak. If you want your stocks to provide quick liquidity, then small-caps are not for you.

If you step back and look at all the characteristics of small-cap investing that I've listed above, you'll see that there's a very poor match between these requirements and the way funds need to operate. Funds need to be liquid, they need to invest in relatively large chunks, and their investors tend to be sensitive to sharp volatility.

What's worse, whenever the NAV drops sharply, a certain proportion of fund investors tend to redeem their investments in a rush. These redemptions are precisely what small-cap funds can't handle at that point. In a general downturn, all these effects-NAV decline, loss of liquidity, impact cost of selling tend to multiply with each other and produce a huge negative impact.

As I said, true small cap investing may be inherently unsuited to funds, at least the way fund investing is done in India currently. Even if you, as an investor in a small-cap fund understand the issues involved and are willing to play the long game, your fellow investors are unlikely to do so. Small-cap investing is an inherently tricky activity. It may be suited only to investors who are knowledgeable, patient and don't mind paying a percentage game.