Mutual funds eye micro stars as broader equity market gathers pace

Outperformance lures fund houses to explore micro-cap schemes; challenging space, say experts

At a time when investors are preferring higher-risk investment products like thematic and small-cap mutual fund (MF) schemes, some fund houses are exploring the possibility of going further down the market-capitalisation (m-cap) ladder to unearth newer investment opportunities.

HDFC MF had filed papers with the capital markets regulator — the Securities and Exchange Board of India (Sebi) — earlier this year for an active micro-cap scheme. Some more fund houses are keen on launching such schemes, say industry observers.

In general, a stock is considered to be a micro-cap if it is ranked below 500 in terms of full m-cap in the listed equity space or if its m-cap is below Rs 1,000 crore.

A micro-cap scheme makes sense if past performance of the Nifty Microcap 250 Index is taken into consideration. The index has delivered an annualised return of 56 per cent in three years.

By comparison, the large-cap National Stock Exchange Nifty50 has delivered a compound annual growth rate (CAGR) return of 21 per cent. Over 10 years, the micro-cap index (23 per cent CAGR) has delivered nearly twice the return of the Nifty50 (11.3 per cent CAGR), reveals Bloomberg data.

Irrespective of the strong performance over the years, experts find the micro-cap space fraught with risks, mostly due to the non-availability of enough information for a comprehensive analysis and lower corporate governance standards at smaller companies.

Analyst coverage on stocks ranked below 500 in terms of m-cap is also rare. Moreover, liquidity is generally low for such companies.

“Micro-caps are only a small part of the equity market. Large-caps alone account for about 66 per cent of the total m-cap and micro-caps only about 3 per cent. We did some research last month and it shows that the average analyst coverage in the small-cap and micro-cap universe is less than two. Overall, the micro-cap space is a very under-researched segment,” says Pratik Oswal, president-passive funds, Motilal Oswal Asset Management Company.

Analysing and constantly tracking the large universe of micro-cap companies is the biggest challenge in managing a micro-cap fund, especially when there are strict limits on fund management fee as in the case of MFs, according to experts.

Given this limitation, micro-cap stocks are estimated to account for just about 4 per cent of the total assets under management with MFs, most of which are through small-cap schemes.

At present, investors wanting higher micro-cap exposure have some options through portfolio management services and smallcase, apart from direct investment in stocks.

Vishal Dhawan, founder, PlanAhead Wealth Advisors, says an MF offering in the micro-cap space could be helpful for certain investors.

“A lot of investors tend to invest in micro-cap stocks and they would be better off doing it through MFs, which would be well diversified. This is a risky space but investors have a time horizon of over 10 years and the ability to remain unfazed by extreme volatility,” he says.

On the strong performance of the micro-cap index, Oswal highlights the risk resulting from the cyclical nature of the dominant sectors in this space.

“In the index, industrials and consumer discretionary have the highest weight. Both these sectors are cyclical. The performance is also a function of optimism in the market as in the case of small-caps,” he says, adding that the micro-cap index is 30-40 per cent more volatile, compared to the Nifty50.

Abhishek Banerjee, founder, LotusDew, says his micro-cap portfolio for clients works on a strategy that focuses on ‘non-balance sheet’ value indicators to identify the right companies.

“The reputation of the promoter and top management is what we keenly track. It’s a very expensive asset that has been built over its lifetime. Another important thing is how new the product or solution is. Any space which already has larger companies is a tough space to crack for newer ones,” he adds.