Can Indian Smallcap Mutual Fund (MF) Returns Sustain?
Have met many people who have invested in small cap due to past high returns & in expectation of the same continuing in near future. Lets delve deeper.
Brief -
“The Indian smallcap MF has reached a historic AUM of Rs 2.3 Lakh crore & the Equity large-cap category has an AUM of 2.96 Lakh crore”
As of 8 Feb, 2024. Source - Moneycontrol.
Re-read the above quote before you delve any further.
Where can the Small cap MF category invest in?
According to SEBI rules, they must invest a minimum of 65% of the total portfolio into the small-cap category. The highest small-cap company market cap is Rs 25,000 crore (Souce NSE as of 31-12-2023).
So the managers of small-cap funds need to invest 65% of their portfolio in companies below Rs 25,000 crore market cap.
What have been the reasons behind the meteoric rise in AUM?
Abundant liquidity
Increased awareness among Indians about Mutual Funds as an investable category
Higher earnings growth or tailwinds enjoyed by small-cap companies
Any other that you can think of :)
Before we proceed I would like to show the Asset under Management (AUM) of just the top 5 small-cap MFs sorted by highest AUM -
Nippon Small-cap MF
I would like to highlight small cap MF with Nippon small cap Fund example & request you to evaluate small cap fund you hold (or plan to) similarly -
Number of stocks held - 205. Yes, you read that right Nippon small cap fund has 205 stocks. With 43,000 crore AUM you need that number of stocks to at least invest the portfolio because of less stake available in public in small-cap companies. But the problem with high AUM arises, let’s understand it.
Example - Bikaji Foods has a market cap of 13,000 crores & promoter owns 75%, so 25% of the stake worth 3250 cr is listed (approximately). So even if the fund manager wants to take 5% of AUM (2000 cr approx.) bet on the company, it would be impossible as the fund manager can’t buy more than 10% (1300 cr) of Bikaji foods according to SEBI rules. So size is the enemy here.
Expense ratio - for direct it is 0.67% & for the regular plan it is 1.51%. Seems decent.
Fund manager - The Fund has 2 fund managers Samir Rachh & Tejas Seth.
Conclusion of Nippon small cap -
High AUM - The fund AUM has become an enemy forcing it to mimic the Nifty 250 small-cap index.
Investing based on past experience - Many newbies have invested based on past performance but in my opinion - NEVER LOOK AT IT - because future performance will be determined by current portfolio holdings.
The number of stocks - 205 stocks are not easy to manage periodically & having a minor position in the stock (below 2%) which even goes from Rs 100 to Rs 300 won’t matter. You are equal to investing in the NSE smallcap 250 index with a much lower expense ratio
Fund manager - Although the fund manager has been able to generate decent returns in the past, there needs to be some sanity before returns make a comeback.
Conclusion of small-cap category -
Valuation of small-cap category - in the recent past (post-June 2020) the return of small-cap started & reached impeccable levels which look scary to me in most cases.
Also, many companies are being quoted as a multiple of their order book to justify their valuations. For example, a company has an order book of 100 cr, revenue of 30 cr & market of 500 cr. It is being quoted at 5X of the order book (even potential expected order), without giving a thought to the company’s execution capability & execution timelines.
Investing based on past performance - The small cap on a broader basis seems to have reached levels not sustainable in the long term without earnings backing up & people are investing more & more in small caps without giving thought to valuation & where the money is being invested & at what valuations.
This article is just to raise awareness amongst small-cap MF investors to re-look at the fund & adjust their allocation towards some other investment avenues. Otherwise, they will end up burning their fingers, trust in financial markets & hard-earned money.
Think again, you have time left to decide, the clock is ticking.
Disclosure - no holdings & not a buy/sell recommendation
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This article was published after a year gap, but from now onwards there will be periodic articles on financial markets & awareness. If you find some interesting topic that can be researched let me know at +91-7567473055 or chirag.jain48@yahoo.com.