Small-cap Mutual Funds On A Roll: Should You Invest Now?
Oct 04, 2017

Author: PersonalFN Content & Research Team

At a time when the economy seems to be stuttering, stock market investors are betting big on future growth.

Unfortunately, much is needed to revive the Indian economy. Economic growth has systematically fallen from 7.9% for the quarter ended June 2016 to a multi-year low of 5.7% in April-June 2017. Yet, over the past year –

The S&P BSE Sensex is up 12%,

The S&P BSE Mid Cap is a few percentage points higher at 16%, and

The S&P BSE Small Cap has risen a massive 24%!!

Mutual funds investing in similar market-cap stocks have delivered returns in line with their benchmarks. Unsurprisingly, Small-cap Funds top the list of equity mutual fund categories with returns in excess of 20%. In terms of returns, Small-cap funds may seem like the Best Mutual Funds in 2017, but don’t undermine the risk.

Before we go deeper in the systematic risks, let’s take a look at the valuations in this space.
 

S&P BSE Small Cap – Grossly Overvalued

Data as on October 3, 2017
(Source: bseindia.com, PersonalFN Research)


As seen in the chart above, small-cap valuations have soared with the market prices. This is a clear indication that earnings of companies have not grown in line with market expectations. Over the past couple of years, though the Small Cap index is up nearly 20% compounded, earnings over the same period have grown by a mere 6%-7%. Clearly, investors are over-optimistic, thus the index commands a mindboggling price-to-earnings (P/E) of nearly 80 times.

Having said this, it is important to note that the S&P BSE Small Cap index consists of 852 stocks that range from a market-cap of Rs 7 crore to high as Rs 22,800 crore. On the other hand, most mutual fund schemes hold a portfolio of up to 70 stocks. Hence, the index valuations may not be truly representative of the portfolio holdings in the Small-cap funds. Nonetheless, the soaring valuations in the space cannot be ignored.

What has been driving up the prices?

As the markets hit new highs, retail investors are flooding the market through mutual funds. Over the past year, mutual funds have invested a whopping Rs 1.17 lakh crore. As funds need to stick to their investment mandate, a bulk of these inflows moves into stocks, even though valuations may seem unsustainable.

This has kept markets afloat even though foreign investors have sold as much as Rs 25,000 crore in August-September 2017. The strong retail investor inflows have been oblivious to the high market valuations and faltering economy.

Many fund houses such as DSP BlackRock Mutual Fund, Mirae Asset Mutual Fund and SBI Mutual Fund have restricted inflows into small-and mid-cap oriented schemes given the high valuations and liquidity risk. Other schemes are gradually shifting from mid-and small-caps to large-caps.

Yet, not all small-cap schemes may be equipped to handle the liquidity risk. In case markets fall substantially, the fund will have two options: 1) sell stocks that are liquid (ignoring their attractiveness), or 2) sell weaker and illiquid assets. If a fund chooses to exercise the first alternative, it will end up holding a poor quality portfolio of illiquid assets. Alternatively, by popping off weak and illiquid stocks, it may incur heavy losses.

With the burgeoning of assets under management (AUM), the high allocation to certain small-cap stocks can certainly pose a high liquidity risk for these schemes. If these stocks buckle under pressure, it will be difficult for the fund manager to get rid of them in time.

As an investor, you have little say on how the fund manager chooses to manage your portfolio. This is why you need to prudently select the right mutual fund schemes. This should be combined with factors like your age, risk tolerance, investment horizon, investment objective, financial goals, and so on.

It’s difficult to predict when the market will favour large-cap or mid-cap stocks. So, it’s a good idea to include a mix of different categories of fund strategically in your portfolio. Given the high valuations in the small-and mid-cap space, these funds may run into high volatility.

An investor looking for lesser volatility or relatively stable returns can consider investing in large-cap funds or balanced funds.

Those who are unsure about which mutual fund schemes to invest in may try PersonalFN’s unbiased mutual fund research services. Along with quantitative parameters such as performance, PersonalFN also considers qualitative parameters such as portfolio characteristics while analysing mutual fund schemes.

We strongly suggest you subscribe to FundSelect Plus and benefit from the SEVEN time-tested, readymade equity and debt mutual fund portfolios.Based on your risk profile and investment horizon, you can choose out of three equity portfolios and three debt portfolios. In addition, you get a readymade tax-saving portfolio as well.

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