Why are MFs launching small-cap funds when their valuations seem too high?

 Systematic investment plans (SIPs) into mutual funds hit an all-time high in September, crossing the Rs 16,000-crore mark for the first time while inflows into small and midcap funds moderated amid sky-high valuations in some stocks. 

The quantum of net flows in both the small-cap and the midcap as a category saw a dip compared to the previous months the the two were still among the highest recipients of net inflows in September.

"The dip in the net flows of these categories could be attributed to some bit of profit booking by investors coupled with concerns regarding inflated valuations in some of these segments," said Melvyn Santarita, Analyst – Manager Research, Morningstar Investment Adviser India.

Even though net inflows into small-cap funds were down by 37% at Rs 2,678.47 in September 2023, fund houses are undeterred when it comes to new fund offers. 

In the last week alone  Baroda BNP Paribas MF launched the Baroda BNP Paribas Small Cap Fund,’ marking the 23rd actively-managed scheme in this category, while Quantum launched the Quantum Small Cap Fund, an open-ended equity scheme predominantly investing in small-cap stocks. 

The Quantum NFO will allocate 65-100% in equity and equity-related instruments of small-cap companies, 0-35% in equity and equity-related instruments of companies other than small-cap companies, and 0-35% in debt and money market instruments.

The Baroda BNP Paribas Small Cap Fund will allocate over 65 per cent of net assets to small-cap companies. Point to note: Existing small-cap funds currently hold 80 per cent in small-caps, with 15 per cent in mid-caps and remaining in large caps. 

ICIC Pru Smallcap and DSP Small Cap have the highest allocation to small-cap stocks currently.

Several fund houses like Nippon India Mutual Fund and Tata Mutual Fund have also stopped accepting fresh lump sum investments in their respective small-cap schemes due to the huge run-up in the prices of most small-cap stocks that have made their valuations soar. 

“The step was warranted given the recent sharp rally in the small-cap space and increasing investor participation through high-ticket investments. We thought it is in the best long-term interest of investors in the fund for money to arrive in a more calibrated manner,” according to Samir Rachh, Fund Manager-Equity, Nippon India Mutual Fund. Small-cap is a comparatively less liquid space and has high impact cost.

Yet both Baroda BNP Paribas and Quantum are bullish on the long-term growth perspective of several high-growth companies in this space. 

"Over the last year, the returns from small-cap mutual funds have been in the range of 25-30%, far outpacing the large-cap funds. Typically, retail investors chase past returns of mutual funds. When the rally is so strong, they also tend to underestimate the risk profile of the asset class. So, naturally, the SIP inflow in small caps has risen. This is an excellent opportunity for fund managers to leverage the momentum and launch new small-cap funds," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

Small Caps Account for More than 85% of All Listed Companies: Quantum Mutual Fund

"On an aggregate basis, valuations might look a tad expensive but if you carefully analyse the large universe of 900+ stocks with meaningful liquidity and market caps, we do find opportunities which are growing fast and appear reasonably priced. Also, we do see an opportunity for a fund in the small-cap space that is mindful of capacity that emanates from liquidity and market cap constraints, one that does not have long tails with sub-optimal weights in the portfolio and one that’s true to label. There is a relatively higher risk in the small-cap investing and we don’t want to enhance risks like that of liquidity or over-diversification in the fund," said Chirag Mehta, Chief Investment Officer, Quantum.

Small caps are more diverse, hence offering new opportunities

Top 3 sectors in Large Cap: 66% of market cap; in Small Cap: 41%

Data As on: September 30, 2023 Source: BSE, Compiled By: Quantum AMC 
Suresh Soni, CEO, Baroda BNP Paribas Mutual Fund agrees. "Small Cap segment offers investment options across a wide range of sectors and is characterised by relatively high growth rates.”

2023 has witnessed a broad-based rally, with mid and small-caps leading the gains. The large-cap Nifty 50 Index is up by ~9-10% on a year-to-date basis, but the Midcap Index as well as Smallcap Index both are up much more with gains of 28-30%.

Investors should tread with caution

Small caps are riskier than their large-cap counterparts but they also have the potential to generate higher returns.

"Investors with high-risk appetites can allocate up to 10-15% of their equity portfolio to small caps through SIP. Since small-caps have overheated for now, they should avoid lumpsum investments. They should stick to their original allocation by rebalancing their portfolio during extended rallies," said Kulkarni.

For example, an investor with a total portfolio of Rs 10 lakh has a 10% allocation to small-caps. If her small-cap portion appreciates by 15% due to a market rally, the absolute value of small-cap stocks or mutual funds would be Rs 1,15,000. In this case, she can sell small caps worth Rs 15,000. Depending on her overall asset allocation and financial goals, she can move the proceeds to large-caps, debt, or any other asset class.

"Within mid and small-cap certain sectors and companies trading at very high valuation multiples can see some correction, so the SIP approach would be more prudent. We can take exposure to mid and small caps while keeping in mind that they tend to be more volatile than large caps. If you are a long-term investor, this should not discourage you, as volatility tends to decrease over time. Over a longer period, this segment has the potential to outperform large caps, making it a very useful part of portfolio allocation for most investors," said Anil Ghelani, CFA, Head–Passive Investments and Products, DSP Mutual Fund.

Not more than 20% to small-caps

Financial Planner Chaitali Dutta recommends investing in a small-cap NFO  by way of SIPs as per the risk profile of the investor. The exposure to this segment is recommended to be capped at 20% of the overall equity exposure, as a general thumb rule.

 Small Caps are high-risk but also capable of high returns. The inclusion of small caps in the investments should therefore be taken in a measured way. 

" If the accumulation for a goal that is 7 to 10 years away, the investor may allocate some  percentage towards small cap as these have the potential to give multifold returns in the longer span of time. On the other hand, investors who have just begun their investing journey, should avoid exposure to smallcap equity. Large cap or their index funds should be the choice of equity to add in the initial years," said Dutta.

 Despite the higher index levels of small caps it is prudent to note that the PE ratios of this segment are not at historic highs as seen in the chart below:

Source:trendlyne.com

Pink line is the Nifty small cap 100 index levels. As you can see at an all-time high of 12,941. The green graph indicates the PE ratio over the same 5-year period.  It was the highest in April 2021. Today the PE ratio levels are compelling.

" The valuations indicate that we are getting similar valuations as of pre-2010 years. Hence it is the compelling valuation of small caps which are likely to give significant growth opportunities in the coming years," said Dutta.

When it comes to small-cap funds, beware of what happens after a blockbuster year

Value Research explains this with an example: The average small-cap fund returns in 2014 were around 87 per cent, followed by 10.32 per cent and 5.18 per cent in 2015 and 2016, respectively. Again in 2017, the small-cap funds gave returns of 54.54 per cent. But that was followed by negative returns in 2018 (-18.71 per cent) and 2019 (-1.47 per cent). Likewise in 2022, small-cap funds were in the red after giving returns of 63.13 per cent in 2021 and 30.52 per cent in 2020. 

"While we aren't predicting 2024 to reverse the fortunes of small- and mid-cap funds, we simply urge you to stay cautious. Only invest in small- and mid-cap funds if you have at least a five-year time horizon.

Last but not least, we'd suggest you invest only up to 20 per cent of your money in small- and mid-cap funds. Because, to borrow Warren Buffett's words, "Be fearful when others are greedy," said Chirag Madia of Value Research.