Is micro-cap index better than small caps?

A user recently asked us if investing in the Nifty Microcap 250 index would benefit more than investing in the small-cap index. (For the uninitiated, the Nifty Microcap 250 Index tracks the 501st to 750th largest companies by market value). This query stems from the remarkable 56 per cent returns the micro-cap index delivered over the past year, beating the small-cap index by a notable 8.6 per cent. Its long-term performance is impressive, too. The Nifty Microcap 250 index has outperformed the Nifty Smallcap index 69.5 per cent of the time and the Nifty 500 index 53.7 per cent of the time based on five-year rolling returns from April 1, 2010. While these numbers underline the potential of the micro-cap universe, particularly when markets rally, this outperformance comes with its own unique set of risks. Risks of investing in micro-cap index 1. Lack of liquidity The limited trading volumes of micro-cap companies make it difficult to buy or sell large quantities without causing price fluctuations. This lack of liquidity can lead to price distortions, especially during times of low market activity, which may negatively impact the returns on your investment. 2. High mortality Although the Nifty Microcap 250 index was launched in July 2021, we simulated how stocks from 2019 would have fit into the micro-cap index, and here's what we found: More than half of the stocks in the micro-cap index would have been relegated to the lower leagues in the last five years, negatively impacting the overall returns of the microcap index. Roughly only one in 10 micro-cap companies would have been promoted to the mid- and small-cap indices. About 29 per cent of the worst-performing large-, mid- or small-cap stocks were relegated to the micro-cap universe due to their history of poor performance. These stocks could also affect the micro-cap index's performance. High churn in micro-cap index Particulars Small Cap Index Mid Cap Index Micro Cap Index Promoted stocks 8.80% 12.67% 10.80% Stagnant stocks 37.60% 44.67% 21.20% Dropped stocks