Why are Mutual Fund Houses Pausing or Limiting Investments in Small Cap Funds

July 11, 2023 Mutual Fund

The exuberant mood at Dalal Street is pushing Indian equities to new lifetime highs. A variety of factors have bolstered investors’ confidence, and the realised volatility has reduced. The bellwether index, i.e., the S&P BSE Sensex, along with the one representing smaller companies — the S&P BSE Midcap Index and the S&P BSE Smallcap Index — have clocked stellar absolute returns on a year-to-date basis and faired impressively since the COVID-19 lows of the market.

Table 1: YTD Returns clocked across market cap segments

Data as of July 7, 2023.
Past performance is not an indicator of future returns.
(Source: ACE MF) 

Enchanted by the returns, investors have been deploying their investible surplus mainly in Midcap and Smallcap Funds over the last two years, shows the AMFI data (see graph below).

Graph: Inflows into Largecap, Midcap and Smallcap Funds

Data as of June 2023.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: AMFI, Data collated by PersonalFN Research) 

And Smallcap Funds, particularly, have rewarded investors handsomely. In the last three-year period, Quant Small Cap Fund, Nippon India Small Cap Fund, Canara Robeco Small Cap Fund, HDFC Small Cap Fund, and Tata Small Cap Fund have been among the five top-performing Small Cap Funds.

Table 2: Performance of Small Cap Funds

Data as of July 7, 2023
The list above is not exhaustive.
The securities quoted are for illustration only and are not recommendatory.
Direct Plan-Growth option considered.
Returns considered are point-to-point and expressed in %.
Returns over 1 year are compounded annualised; else absolute.
Standard Deviation indicates Total Risk, while Sharpe and Sortino Ratios measure the Risk-Adjusted Return. They are calculated over a 3-Yr period assuming a risk-free rate of 6% p.a
Past performance is not an indicator of future returns.
The table above is NOT a recommendation as such. Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF; Data collated by PersonalFN Research) 

[Read: 5 Best Small Cap Mutual Funds to Invest in 2023]

At such compounded annualised returns over the last three years, certain Small Cap Funds have more than doubled investors hard-earned. Fascinated by the returns, more and more investors have been deploying their investible surplus into Small Cap Funds, particularly in 2023.

However, now it appears that mutual fund houses are going bellyful or surfeit. To put it simply, they are now dealing with a ‘problem of plenty’. Recently, Nippon India Small Cap Fund temporarily stopped accepting fresh lumpsum investments plus enforced a limit for new SIPs (Systematic Investment Plans).

[Read: Nippon India Mutual Fund Limits Lumpsum Subscriptions in Nippon India Small Cap Fund]

Earlier, towards the end of June 2023, Tata Mutual Fund also temporarily stopped fresh inflows into Tata Small Cap Fund.

HDFC Mutual Fund, which launched its new fund, HDFC Defence Fund in May 2023, a month later announced temporarily discontinuing lumpsum investment and restricted SIP transactions.

SBI Mutual Fund, one of the largest fund houses, has also suspended lumpsum investments in its SBI Small Cap Fund since September 2020 and is currently accepting SIP investments up to Rs 25,000.

So, why are mutual fund houses pausing or limiting fresh investments in certain schemes?

Well, it is mainly the valuations.

A fact is that Indian equities are trading at a premium relative to their global peers. The Morgan Stanley Capital International (MSCI) India Index Price-to-Equity (P/E/) ratio is nearly 26x, while the MSCI Emerging Markets Index and MSCI World Index trail P/Es are around 14x and 20x (as per the latest factsheets). Even on a 12-month forward P/E, India is commanding a premium vis-a-vis emerging markets and the world.

India’s market capitalisation-to-GDP ratio, famously called the Buffett indicator (named after legendary investor Warren Buffett), has also moved up from 87.4% to 95.9%, and is near the modestly overvalued range.

In the smallcap segment particularly, valuations look rather stretched. The Smallcap-to-Sensex ratio is above the long-term average. Fund management teams aren’t finding much ‘value’ at the current levels, and perceiving the margin of safety seems to have narrowed. Therefore, a cautious approach is practised, even though they are confident of the wealth creation potential of midcaps and smallcaps going forward.

The notice-cum-addendum issued by Nippon India Mutual Fund states:

“The limit on subscription of units of the Scheme is being proposed to facilitate gradual deployment of corpus in order to align with the nature of small cap investing. The step is warranted considering the recent sharp rally in the small cap space and increased investor participation through high ticket investments which would be in the best interest of existing unit holders and appropriate for incremental investments.”

Even Tata Mutual Fund while suspending inflows in Tata Small Cap Fund, stated that it could be challenging to deploy fresh inflows at these levels.

In the case of the HDFC Defence Fund, recognising that Nifty India Defence Index has surged to a record high in the recent past, HDFC Mutual Fund discontinued lumpsum subscriptions and put restrictions on SIPs.

Overall, fund houses temporarily pausing or limiting fresh investment into schemes is part of a well-thought-out strategy to safeguard the interest of existing investors.

You see, while valuation may look kind of justified given India is a bright spot in the global economy and earnings have been encouraging, a further rise in the market cap segments may place Indian equities in the overall valued range.

How should new investors approach Smallcap Funds?

It would prove unwise to get carried away by irrational exuberance and unrealistic earnings estimates for smallcaps and expect them to deliver astronomical returns year-on-year. For the Indian equity markets, the risk emanates from further rate hikes by major central banks, chances of a global recession, increasing global debt-to-GDP ratio, El Nino condition, higher food prices, and geopolitical tensions. Thus, avoid going gung-ho, instead tread cautiously. In the words of legendary investor, Warren Buffett, “Be fearful when others are greedy, and greedy when others are fearful.” 

When deploying hard-earned money in mutual funds, consider your age, risk appetite, investment objective, financial goals, and the time in hand to achieve the envisioned to make a suitable and thoughtful choice among a plethora of mutual fund schemes.

At present, it would be sensible to avoid going overweight or skewing the investment portfolio to Smallcap Funds. By and large, consider mostly some of the best Largecap Funds, Flexi-cap Funds/Multi-cap Funds, and Value/Contra Funds as part of the ‘core portfolio’. They shall add stability to the investment portfolio and potentially multiply wealth and accomplish the envisioned financial goals. At a market high, consider making staggered lump sum investments, or even better making SIP investments.https://www.youtube.com/embed/iWhtt1dinrs 

[Read: Should You Kick-start Your SIPs Amid Market Highs?]

SIPs shall instil the investment discipline, help mitigate volatility (with the inherent rupee-cost averaging feature) and enable compounding hard-earned money. That said, select some of the worthy mutual fund schemes, invest a meaningful sum of money, do not discontinue or pause SIPs when the markets hit turbulence, and give enough time for SIPs to grow.

Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here