Small Cap Funds :Lucrative or Ludicrous?

In the planet called financial markets, mutual fund segment is a continent. It’s a gamut of funds which may seem endless to most of us. However categories like blue-chip, sectoral and small-mid cap funds simplify it for us. This specifically helps us to filter, until we boil down to the requisite fund.

Let us further delve into what the general sentiments while investing are, especially in context with small cap mutual fund.

When the rains are good, prosperity reins. So when the markets are all gung –ho and its high flying, small and midcap funds flourish. But when markets tank these funds are butchered. Thus it is important to analyze, at this juncture, how investment in small cap stocks or small cap focused mutual funds has done so far and also expound on how the future looks.

                  BSE SMALL CAP V/S BSE 200                                  Are small caps bottoming out?                                                  

    

As the graphs above indicates the BSE 200 index is far more stable in comparison to the bse small cap. The small caps are known to be more volatile stocks.

 The graph on the left hand side shows that if one had invested a sum of Rs. 10,000 in BSE Small cap in May, 2007, five year later the investment would have returned just Rs. 8,500 - destruction of wealth. Similar investment in BSE 200 done on the same day would have fetched Rs. 11,500 in May, 2012. The graph on the right hand side again highlights the violent nature of the small caps. Investment done in BSE Small cap even at the market bottom in March 2009 would have performed only at par with BSE 200 if one were to hold it till May, 2012. Those who could sell in November 2010 would have made huge profits; but which is very unlikely in the case of retail investors. 

Trends:

From 2003-2008 when the bulls were feasting, the small cap mutual funds went into frenzy. However Small cap funds which were launched in 2007-08 went spiraling down with the downfall.

Certain data highlights it.                                                                                                          (%)

Name of fund.	NFO DATE	1 Year	3 Years	5 Years	SINCE INCEPTION.
DSPBR Micro-Cap (G)	20-Jun-07	0.1	25.4	-	7.5
Religare Mid N Small Cap (G)	18-Mar-08	-2.0	23.4	-	7.5
IDFC Sterling Equity (G)	7-Mar-08	-0.4	19.8	-	14.3
DSPBR Small & Mid Cap (G)	16-Nov-06	-5.0	18.5	7.7	8.8
JPMorgan India Smaller Cos (G)	27-Dec-07	-4.4	16.7	-	-7.1
Franklin India Smaller Cos (G)	13-Jan-06	-7.5	12.7	2.5	4.0
Sundaram S.M.I.L.E Fund (G)	16-Feb-05	-8.9	8.6	7.5	14.6
HSBC Small Cap (G)	31-Mar-08	-18.8	6.2	-	-4.5
Reliance Small Cap (G)	21-Sep-10	-9.7	-	-	-7.3
BSE SMALLCAP	20-Jun-07	-22.6	4.2	-2.9	-

This table implies:

The table above reveals that small cap funds have fared better than the BSE small cap Index on different time frames. This is mainly due to the asset allocation these funds have broadly followed. By and large, small cap focused funds invest minimum 65% of assets in small cap companies; however, they have a flexibility to invest about 35% of assets in stocks other than small caps. In other words, these funds can invest about 1/3rd of their portfolio in large caps or larger midcaps. This provides them some stability when the small caps are shunned by the market.

The small cap fund varies with the % of small cap stock allocation. This table below gives an approximate range of small cap stocks in the fund.

Scheme Name	Total AUM	% in small cap	Small Caps (in %)
DSPBR Small & Mid Cap (G)	1205.04	319.82	26.5%
DSPBR Micro-Cap (G)	454.04	316.29	69.7%
Reliance Small Cap (G)	436.00	287.92	66.0%
Sundaram S.M.I.L.E Fund (G)	468.93	168.42	35.9%
IDFC Sterling Equity (G)	1097.74	143.18	13.0%
Franklin India Smaller Cos (G)	333.91	88.49	26.5%
HSBC Small Cap (G)	20.53	17.45	85.0%
Religare Mid N Small Cap (G)	17.31	3.36	19.4%

Risk Component

Smaller companies are more vulnerable to external shocks. Such companies may go under water if the crisis situation persists for longer than anticipated period. Small cap companies may not have the muscle to sustain losses for long or they may fall drastically if the revenue growth becomes flattish and they have a high debt to service ratio. Smaller companies often find it difficult to invest in research and development and they go completely out of flavor if the technology which made them successful becomes out dated. These risks are fundamental in nature and directly affect the return potential of your investments. 

Also fund managers cannot offload a huge chunk of shares of the company at one go. It has to offloaded and bought systematically in smaller lots. Hence it becomes difficult for the fund manager to strike a balance between fundamental strengths of the company and technical difficulties in buying its common shares in large quantities.

Future tripBSE Sensex has already fallen by more than 5% over last one month. European Sovereign debt issue seems far from solved and the markets are fluctuating like a pendulum. No rally in Indian equities has sustained so far since the markets topped in November 2010. After the recent slide in the market, small caps may have given the feeling that they have become cheaper in valuation; they might have in deed, but that shouldn’t be the basis for investing in a pure small cap fund or a fund with a higher exposure to small caps.

Verdict

Small caps have usually done well when markets have been robust. These are capitalized on when blue chip and midcap looks expensive. Markets seem on the lower side valuation of small cap may seem cheap .This could add to the possibility of panic selling if markets further deteriorates. So a fund with a judicious mix of small cap and large cap with the right timing to enter and exit the market seems like a prudent bet.