Small stocks, big risks

Redemption in smallcap funds can create challenges

Arecent exchange of communication between the Association of Mutual Funds in India (AMFI) and the Securities and Exchange Board of India (Sebi) culminated in a letter from the AMFI to asset management companies (AMCs), asking them to plan and implement proactive measures to protect investors with high exposures to smallcap and midcap funds. The AMFI cited Sebi’s concerns about “froth” in smaller stocks and asked fund trustees and unitholder protection committees to implement protective measures and announce them within 21 days on their respective websites. This is unusual. While Sebi is always concerned about risks to investors, buying units is the least risky route to equity investing. The regulator also doesn’t normally concern itself with market valuation. However, this is the fifth year running when smallcap funds are logging double-digit capital gains and retail investors hold the vast majority of equity units. So in the case of correction, individual investors are most at risk. One characteristic of small stocks is the lack of liquidity. Hence, large institutional trades have a big impact on prices. Heavy selling may trigger a very sharp correction.

Valuations and returns on small stocks are elevated. The benchmark Nifty 50 has a 12-month return of 26 per cent while the Nifty 250 smallcap has a return of 65 per cent. The Nifty 250 smallcap is valued at a trailing price-to-earnings ratio of 28, while the Nifty is at 23. In April-January FY24 net inflows into smallcap funds crossed Rs 37,360 crore, as against Rs 22,103 crore in FY23. Most of this is via systematic investment plans (SIPs). When valuations are “frothy”, fund managers can opt to park larger proportions in cash and other assets. But funds are mandated to invest at least 65 per cent of the corpus in the stated equity segment. The mandate itself may become a challenge for funds with enhanced cash holdings and high inflows. The funds may consider limiting inflows to avoid being forced to buy at high valuations. However, there is also the consideration that investors may deploy surplus funds directly in the market, which could actually heighten risks. Many funds have limited inflows by capping lump sum investments and SIPs.

Most funds are open-ended. Hence, large-scale redemption can force managers to sell stocks. That can lead to a negative feedback loop: Funds selling to meet redemption, leading to price correction, triggering more redemption, and more selling and so on. The AMFI has asked AMCs to watch out for “first-mover” sellers initiating a cascading effect. Portfolio rebalancing — booking profit in stocks which have run up, in order to buy others trading at more attractive valuation — is another option. But here too, the flexibility to switch assets is limited by the mandate, and the size of the smallcap/midcap segment. About 150 midcaps and 500 smallcaps already have significant institutional holdings. Managers may need to rebalance with assets outside these segments. Thus, limiting risk proactively will be a challenge. Sebi could consider a more flexible mandate, perhaps using a sliding scale tied to valuation. It could also consider arranging alternative sources of cash for funds faced with sudden redemption demand in order to avoid the impact cost of high-volume sales.