Motilal MF’s new micro-cap index fund tests the limits

Separately, HDFC Mutual Fund has filed a scheme information document (SID) for an actively managed micro-cap fund called HDFC Emerging India Opportunities Fund under the thematic category. This fund will have a broader investment universe with stocks beyond the NSE 500 companies, including those listed on the NSE EMERGE and BSE SME platforms.

Other asset management companies (AMCs) in India may follow suit and launch funds in the micro-cap space. To be sure, there is no specific classification for the micro-cap segment. The Securities and Exchange Board of India (Sebi) has categorized the first 100 stocks based on market capitalization as large-cap, stocks ranked between 101 and 250 as mid-cap, and those beyond 250 as small-cap companies.

Investing in micro-cap companies comes with higher risks due to the inherent nature of their businesses and their size. There is also the possibility of companies getting delisted from this segment.

“Micro-cap stocks come under the high-risk, high-return category. These companies have massive information issues. We can’t really comment on their governance because we don’t know what’s really going on. And typically, there tends to be wild swings in the stock prices. Liquidity is another big issue," said Anubhav Srivastava, managing partner at Aryzen Capital Advisors.

While returns on investments in the micro-cap space could be higher in the long run, these investments are highly volatile and prone to fluctuations in the short term.

According to the rolling return analysis data given by Motilal Oswal MF for the period from 2010 to 2023, the average five-year return and 10-year return of the Nifty Microcap 250 Index were 13.4% and 15%, respectively. In comparison, the Nifty Smallcap 250 TRI Index achieved returns of 11.6% and 12.5%, respectively, over a similar period.

Here’s how the indices performed during stressful times in the market. Historically, the small- and micro-cap segments have experienced a deeper and longer drawdown. For instance, during the global financial crisis from January 2008 to October 2008, the micro-cap index plummeted a staggering 76%. During the same period, the Nifty Small Cap and the benchmark Nifty 50 TRI indices experienced corrections of 70% and 60%, respectively. A similar pattern emerged during the market decline amid the covid crisis in 2020 as well.

Therefore, investing in the micro-cap space is only suitable for individuals who can stomach high levels of volatility and maintain a longer investment horizon. Even on a five-year basis, the micro-cap index delivered negative returns 15% of the time (9% for small-cap) between April 2010 and May 2023.

Funds in India

Currently, while there are no open-ended equity mutual funds in India specifically focusing on micro-cap stocks, note that the existing small-cap funds have about 10% to 45% exposure to stocks ranked beyond NSE 500 depending on the fund we choose.

Before Sebi’s recategorization of mutual funds in 2018, the present DSP Small Cap Fund in its previous avatar was called DSP BlackRock Micro Cap Fund. Launched in 2007, the fund had the mandate to invest at least 65% of the portfolio in micro-cap stocks. The AMC, then, defined micro-cap as those ranking from 301 onwards in terms of market capitalization. It now follows a small-cap fund mandate, investing a minimum of 65% of its assets in stocks ranked 251 onwards.

The fund was considered a star performer in the category for a couple of years.

In small and micro-cap funds, managing liquidity effectively would become a challenge as the fund grows bigger. The DSP fund had to restrict inflows multiple times.

Sundaram Mutual Fund also launched a series of close-ended funds called—long-term micro-cap tax advantage funds—before 2017. Even these funds defined micro-cap as those stocks ranking from 301 on the National Stock Exchange. While a few have matured as of date, there are four series (series III to series VI) that will mature in either 2026 or 2027, as per the AMC’s website.

These funds came with an investment horizon of 10 years and, as of April 2023, have generated returns of just 2-4 percentage points higher than the Nifty Small Cap 100 TRI index, since inception.

Should you invest?

Many advisers and distributors avoid this micro-cap space entirely because of the volatility and the high-risk levels.

“We avoid this segment because I believe most companies in this space remain a micro-cap stock for a longer time and do not transition to a small/mid/large cap segment. Also, the EPS (earnings per share) growth of the companies is not impressive enough," added Amit Bivalkar, founder of sapient wealth Advisors.

As per the Wealth Creation Study by Motilal Oswal for the period 2017 to 2022, only one company in the small-cap (small and micro-cap) space moved to the large-cap category.

“In 2017, there were 2,724 mini-companies (ranked beyond 250). Of these, 1 moved to the large-cap category (top 100) by 2022, clocking a 5-year return CAGR of 65%. 48 minis moved to mid category (next 150) by 2022, delivering a return CAGR of 35% in the process. Next, 2,675 mini companies stayed as mini and delivered a return CAGR of 9%," stated the report.

Those who see some merit in investing in this space recommend investors to be highly cautious. Advisers are further divided on whether one must choose an active or a passive fund in this space. However, there are no actively managed funds in this space yet, but these are expected to be launched soon.

“There’s more scope for generating alpha through active management of funds in this space but a more conservative way for investors is to invest through index funds," added Vishal Chandiramani, chief operating officer at Trust Plutus Wealth.

“If you make the right decision in picking a fund manager, you could make 40-50% higher than what an index fund does. But if the call goes wrong, you can even lose your money. The difference between the best and the worst fund’s performance in this space could be too diverse," said Santosh Joseph, founder of Germinate Investor Services.

Micro-cap investing is only for people with a very high-risk appetite. “One can consider a small portion of the investment in small-cap allocation to invest in micro-cap funds," said Chandiramani.

Is lower liquidity an issue?

The lower liquidity for companies in the micro-cap space poses a significant challenge. Liquidity refers to the ease with which an asset can be bought or sold without a significant impact on its price.

As per a Motilal Oswal report, it takes close to three days to trade ₹100 crore. For index funds, as the portfolio rebalancing happens with the change in the index weights and components, buying and selling companies could be an issue. This will be pronounced as the size of the fund grows bigger.

Pratik Oswal, head of Passive Funds at Motilal Oswal Asset Management, said “Liquidity could be an issue but we are confident of managing the fund, given our experience with our small-cap index fund. Managing effectively is our priority over higher AUM. We don’t see any issue for the next few months. As the AUM of the fund grows, we may also consider limiting inflows (after ₹500 crore).

When investing in a passive fund, note that the tracking error of these funds could be higher than that of small-cap passive funds due to the liquidity issues in the space, said Nirav Karkera, head of research at Fidom. Tracking error measures how well the scheme has managed to replicate the benchmark index. A lower tracking error is considered better. Motilal Oswal Nifty Small cap 250 Index Fund’s recent tracking error stood at about 0.2.