Why Small Cap Mutual Funds are Falling and What Should Investors Do?

March 21, 2024 Mutual Fund

The record-breaking rally in small-cap segment over the last one year has prompted market regulator SEBI to stock of the situation.

According to SEBI Chief Madhabi Puri Buch’s assessment, there is a froth in small and mid-cap stocks owing to ‘off the charts’ valuation in these market segments that are not supported by fundamentals.

She added that the irrational exuberance seen in the segment can result in valuations reaching a bubble zone. If the bubble bursts it can impact investors adversely. SEBI chief further added that the regulator has observed ‘patterns of price manipulation’ in new listing taking place on platform for tiny companies.

Subsequently, the Association of Mutual Funds in India (AMFI) asked mutual fund houses to conduct a stress test for their Small Cap Funds and Mid Cap Funds every 15 days. It also recommended that mutual funds moderate inflows into these schemes and also rebalance the portfolio. Also, it has asked mutual funds to ensure that investors are protected from the first-mover advantage of redeeming members.

The news of froth building in the smaller segment of the market and anticipation of the stress test results made the market nervous, resulting in sell off in small-cap stocks.

The S&P BSE Small-cap index is down about 10% from its peak of February 2024. Small Cap Mutual Funds felt the impact off the meltdown in the lower market cap as they witnessed a decline in NAV in the range of 4-9% in the last one-month period.

Some mutual funds houses have also restricted fresh inflows via lump sum and SIP in their Small-cap schemes. This comes after the Small Cap Fund segment received over Rs 41,000 crore worth of inflows in 2023, double than the inflows seen in 2022 (see graph below). Notably, the high inflows in Small Cap Funds over the past couple of years was one of the reasons driving the stock prices in the small-cap segment.

Small Cap Funds receive strong inflows

#Segment-wise data for 2019 is available from April onwards
Data as of February 29, 2024
(Source: AMFI, data collated by PersonalFN Research)

What is stress test and how have mutual funds fared?

The main purpose of a stress test is to gauge the liquidity of the portfolio. In other words, how many days would it take to liquidate or encash the underlying portfolio in case the fund faces heavy redemption pressure (in case of adverse market conditions).

For this purpose, mutual funds are required to disclose the time required to liquidate 80% of the portfolio to AMFI considering 10% Participating Volume and multiplying it 3 times. The 80% of the portfolio is considered after excluding the least liquid 20% of the portfolio. The liquidity analysis will be done for the balance portfolio by calculating the time required to liquidate 50% and 25% of portfolios on a pro-rata basis.

Here are the results of the stress test disclosed by the fund houses on March 15, 2024:

Scheme Name	AUM (Rs Cr)	Days required to liquidate 25% of the portfolio	Days required to liquidate 50% of the portfolio	Allocation to small-cap stocks in the portfolio (%)
Nippon India Small Cap Fund	46,044	13	27	67.19
HDFC Small Cap Fund	28,599	21	42	77.03
SBI Small Cap Fund	25,525	30	60	80.69
Axis Small Cap Fund	19,606	14	28	67.45
Quant Small Cap Fund	17,193	11	22	65.50
Kotak Small Cap Fund	14,196	17	33	72.79
HSBC Small Cap Fund	13,747	8	15	72.86
DSP Small Cap Fund	13,710	16	32	87.45
Franklin India Smaller Cos Fund	11,823	6	12	75.66
Canara Rob Small Cap Fund	9,595	7	14	70.46
ICICI Pru Smallcap Fund	7,415	5	10	66.99
Tata Small Cap Fund	6,289	18	35	93.61
Aditya Birla SL Small Cap Fund	5,382	5	10	80.67
Bandhan Small Cap Fund	4,389	2	3	69.75
Invesco India Smallcap Fund	3,705	2	4	66.52
UTI Small Cap Fund	3,653	3	5	82.57
Mahindra Manulife Small Cap Fund	3,527	2	4	69.71
Edelweiss Small Cap Fund	3,147	2	3	67.67
Sundaram Small Cap Fund	3,056	3	5	72.86
ITI Small Cap Fund	1,772	1	2	62.43
Motilal Oswal Small Cap Fund	1,491	2	3	72.13
PGIM India Small Cap Fund	1,438	1	3	78.59
Union Small Cap Fund	1,328	1	2	86.21
Baroda BNP Paribas Small Cap Fund	1,325	1	1	78.57
Bank of India Small Cap Fund	920	1	2	73.28
LIC MF Small Cap Fund	212	1	1	87.12
Quantum Small Cap Fund	39	1	1	70.56

(Source: AMFI, ACE MF)

Nippon India Small Cap Fund, the largest scheme in the Small Cap Mutual Fund category will require 13 days to liquidate 25% of its portfolio and 27 days to liquidate 50% of its portfolio. Keeping in mind its large corpus size and lower number of days required compared to a few other prominent schemes, the scheme’s stress test result appears satisfactory.

As per the data disclosed by AMCs, HDFC Small Cap Fund, SBI Small Cap Fund, Axis Small Cap Fund, Quant Small Cap Fund, Kotak Small Cap Fund, DSP Small Cap Fund, and Tata Small Cap Fund will require relatively higher number of days (more than 20 days) to liquidate the portfolio. It is noteworthy, that among the aforementioned schemes, DSP Small Cap Fund and Tata Small Cap Fund hold higher exposure to small-cap stocks (around 90%) as against the category average of 74.7%, making them less liquid.

The lower liquidity in certain schemes suggests that the they may face challenges in quickly meeting redemption demands in case of adverse market conditions as there may not be many buyers. This is one of the reasons why small caps are under pressure.

Will Small Cap Funds continue to be under pressure?

The graph below depicts that even though valuations (S&P BSE Smallcap to Sensex ratio) have cooled off a bit after the recent correction they continue to be above long-term median of 0.44.

Due to the concerns related to expensive valuations, small-cap stocks may continue to be under pressure in the near term as investors may look to book profit and shift to the large-cap segment (which are better placed in terms of valuation).

Valuations in small caps continue to be expensive

Data as of March 19, 2024
(Source: ACE MF, data collated by PersonalFN Research)

That said, the recent market correction may offer fund managers an opportunity to accumulate quality names in the small-cap segment that has become too expensive after the recent run-up in the market.

India’s long-term growth story remains intact as we are witnessing strong micro and macro-economic growth. This bodes well for a sustainable growth in the broader market. Thus, over the long run, Small Cap Funds may continue to prove their high returns potential and outpace their peers in the Mid Cap Fund and Large Cap Fund categories.

What should investors do?

The recent directive by the market regulator SEBI is a positive and necessary move. The stress test and liquidity analysis of small and mid-cap funds is crucial because it provides insight into how easily or challenging it might be for your small and mid-cap mutual fund to convert its investments into cash when the need arises.

The move might also motivate fund managers of Small Cap Funds to be more mindful of the liquidity aspect of the stocks in the portfolio with a view to protect investors’ interest.

However, investors should avoid investing in Small Cap Funds purely on the basis of past returns, as they may or may not sustain in the future. Accordingly, they should set realistic returns expectation from their equity investments and brace for any sharp volatility in the near term. Investors may be better off opting for the Systematic Investment Plan (SIP) mode of investment to mitigate the impact of market volatility.

Given the expensive valuations in the small-cap segment, Small Cap Funds could witness higher downside risk in the case of any negative market event. Thus, investors should be aware of the risk involved and ensure that they match with their risk tolerance. Investors with low to moderate risk appetite and those with an investment horizon of less than 5-7 years should consider shifting their equity allocation to stable investments such as Large-cap oriented mutual funds.

When picking Small Cap Funds for the investment portfolio, investors should prefer schemes that focus on picking quality and liquid stocks in the portfolio. It would be better to avoid schemes that take excessive risk for generating high returns.

Watch this video to find out if your Small Cap Fund is under pressure: