VR Logo

A Wild Ride

Small cap funds have tremendous potential for profits, but are simultaneously a recipe for disaster…

In Value Research’s category classification, 62 funds fall under the ‘Equity: Mid & Small Cap’ category. Of these, just a meager six are primarily focused on small-cap stocks (see The small-cap fund universe). All of them, barring Reliance Small Cap, were launched before the market collapse of 2008.

The performance of these funds is a grim reminder that risky investments do not necessarily deliver high return. In fact, capital erosion is more likely to take place and give you sleepless nights. These funds have had a patchy performance with a large amount of volatility and have not delivered spectacular returns over relatively long periods of time.

In fact, among the five funds that have been around for at least three years (May 31, 2011), three are struggling to stay in positive territory, DSPBR Micro cap and Franklin India Smaller Companies being the better of the lot. L&T Small Cap has the worst 1- and 3-year return. The Net Asset Value (NAV) of L&T Small Cap as on May 31, 2011 was 4.95, far below its face value of Rs 10.

For small-cap funds to work, the investor mindset needs to change. These funds are inherently volatile because small-cap stocks are so. They react adversely to market movements and interest rate hikes and other such issues. When the net asset value (NAV) of such funds accordingly drops, investors tend to panic and pull their money out. A bad move for the investor and the fund manager. The general market downturn and decline in NAV result in negative sentiment and outflows which in turn aggravate the liquidity issues and impact cost of selling. All in all, moves that hit the investor. Investors in small-cap funds must be in for the very long term. They should turn a blind eye to volatility and be ready for a rocky ride. Unfortunately, even if you consider yourself in that league, the rest will not. Your fellow investors are likely to panic, exit and the fund manager will have to liquidate his positions at a loss to meet redemptions, affecting all those who stay in.

Take the case of Franklin India Smaller Companies Fund. Launched in December 2005, the fund gained 56 per cent in 2007 before losing 63 per cent (nearly two third of its value) in 2008. Of course, the fund turned around nicely through 2009 to gain 105 per cent. But nearly two third of initial investors had bailed out of the fund by 2010.

Little wonder that fund houses prefer launching such funds as closed-end offerings. Four of these six funds (Franklin India Smaller Companies, DSPBR Micro Cap Reg, L&T Small Cap and HSBC Small Cap) were launched as closed-end funds which later turned open ended.

Frankly, true small cap investing may be inherently unsuited to funds, at least in India. Yet, ironically, for investors who want a slice of the small-cap pie, then instead of directly buying into such stocks, a safer way is to deploy your money via a small-cap mutual fund. Buy into a wrong company and you could lose all your money. There is some safety (relatively speaking) when you cast your lot with a fund. But when you do so, ensure that no more than 10 per cent of your equity portfolio is allocated to such funds.