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.

3. High tracking error

Funds tracking the micro-cap index (there's just one index fund at the moment) might face a higher tracking error. Due to limited liquidity in this universe, the fund would often find it challenging to closely follow the index's performance, resulting in larger differences between the fund's returns and the index's returns.

4. High volatility

Smaller the companies, the more volatile they are likely to be. Given the context, the micro-cap index sees wild performance swings in the long run. The numbers suggest that, too. Based on five-year rolling returns, the micro-cap index reveals a significantly higher standard deviation (a volatility metric) than mid- and small-cap indices, as shown in the table below.

5. Negative returns history

Although no index is immune to negative returns, the micro-cap index delivered negative five-year rolling returns about 10.2 per cent (490 days) of the time since its inception—far more frequently than the Nifty 500, which found itself in the red just 0.85 per cent (41 days) of the time over the same period.

Furthermore, the micro-cap index tends to suffer more severe declines than broader indices during market downturns.

Our take

While micro caps can potentially deliver higher returns than broader indices, they can be very risky. You need a stomach of steel to ride this roller-coaster of a universe. For this reason, we suggest not allocating a significant portion of your portfolio to the micro-cap index.

Instead, invest that amount in small-cap active funds. They typically invest in micro-cap stocks, too. For instance, of the 727 stocks held by the active small-cap funds (as on 31st July 2024), 162 are a part of the micro-cap index.

Also read:
The body and soul of investing
The micro-cap megastar