The Mutual Fund Show: How To Invest In Small-Cap Funds

Choosing funds based on winners of the past year or last 12-month performance is not a good idea.

<div class="paragraphs"><p>A trader monitors financial data on his computer screens as he works inside a stock exchange (Photographer: Ralph Orlowski/Bloomberg)</p></div>
A trader monitors financial data on his computer screens as he works inside a stock exchange (Photographer: Ralph Orlowski/Bloomberg)

Given the market volatility, investors are often wary of selecting small-cap funds. Financial advisers suggest picking such schemes for the long term.

Choosing funds based on winners of the past year or last 12-month performance is not a good idea, but systematic investment plans or SIPs in small-cap funds is a good strategy if the holding period is longer, Amol Joshi, founder, PlanRupee Investment Services, told BloombergQuint’s Niraj Shah.

“Small-cap companies, although listed, are not very well-tracked and covered in terms of the research aspect," he said. "So, emphasise on the research and the quality of management. It should be a high-growth business ... [with] a reasonable margin of safety.”

Joshi recommends the Nippon India Small Cap Fund as it is the largest in the category and has top quartile performance. The fund has wide sectoral diversification and focuses on investing in growth businesses, high management quality, and rational valuation, he said.

Kirtan Shah, founder and chief executive officer of Credence Wealth, said size is an impediment to the performance and ability to stick to smaller names because of liquidity issues.

According to him, a small-cap fund with lower assets under management, higher exposure to small caps, and a lower turnover ratio works well. He recommends the Quant Small Cap Fund.

Gold ETF Vs Fund Of Fund

To invest in gold, investors can choose gold exchange-traded funds or gold funds with a fund of fund structure where the fund invests in ETFs.

In ETFs, price discovery has been a problem—be it equity, debt or gold ETFs—as they are not as liquid, Joshi said. If an investor plans to buy a few times and hold for a long period, then ETFs make sense.

Many broking platforms do not offer SIPs in ETFs, and therefore, for investors who want to take the SIP route and make smaller purchases over a period, gold funds score over ETFs, said Joshi.

According to Shah, investors should have some exposure to gold for diversification. Gold ETFs are theoretically low cost and do not have an exit load, but Shah said they are meant for savvy investors and not for the retail investor.

“The biggest advantage of a gold ETF, apart from the cost, is to be able to time the market. You can buy it from live markets and pinpoint a price at a particular time that you want to buy it.” In comparison, a fund of fund only gives an investor the end-of-the-day pricing, Shah said.

An investor needs to carefully time the price of buying and selling at the first instance, because illiquidity in the market results in a huge pricing gap. “Retail investors who want to systematically accumulate gold and want to do SIPs would be better off with a gold fund of fund," Shah said.

Watch the full conversation here:

Edited excerpts from the interview:

Are small-cap funds a good sphere to invest in looking at the current uncertainty in the markets? If so, would you choose one of the winners of FY22 or go for a completely different set of funds?

Amol Joshi: If you have a long enough investment horizon, something to the tune of seven to ten years or five years more, then it is a yes. You can choose to invest into small-cap funds. That is for somebody who wants to do the bifurcation as per market capitalisation.

If you have somebody who completely wants a barebone 3,4,5 mutual fund schemes portfolio, then probably a multicap or a flexicap fund as one or two offerings will do good for you.

But if you have decided to invest in a small-cap fund, one such scheme is the Nippon India Small Cap Fund. It is incidentally also the largest mutual fund small cap scheme by assets under management.

It is one of the better performing schemes, not just over the last one year, but over the last three years, five years, and 10 years – across timeframes it has consistently managed to beat the benchmark. So, they certainly have something right going on.

Small cap companies, although listed, are not very well-tracked and covered in terms of the research aspect. So, you emphasise a lot on the research, on the quality of management. Your business should be a high-growth business, and all said and done, you should have a reasonable margin of safety. In other words, you should not overpay in buying the business. That's the philosophy that this fund uses.

You can look at investing into small-cap funds if you have a long-term investment horizon and you can look at one of the better performing schemes.

The best performing small cap funds of FY22 includes Quant Small Cap Fund – probably the best performing fund – but Quant Small Cap Fund, Canara Robeco Small Cap Fund, Nippon India Small Cap Fund and BOI Axa Small Cap Fund, each delivered returns northwards of 40% with some delivering returns of about 50%. Kirtan, are you in favour of clients choosing small-cap funds? Are you choosing one of the better performing funds of FY22?

Kirtan Shah: Ideally, if you look at the risk return data points, the answer to this question is very simple.

If you allocate equal proportion to a large, mid, small cap versus a multicap or versus flexicap, you will see that on a risk-return basis, the large, mid and small cap has delivered a much superior performance then investing in a multicap or a flexicap.

For somebody who is very clear that they have five, seven years of investment horizon at least, should definitely do a large, mid, and small cap bifurcation in the fund than choosing a multicap or a flexicap.

That is a better portfolio building strategy than just investing in two-three multicaps or flexicaps and let the fund manager decide what they really want to do.

While you're trying to look at investing in a small cap, I would definitely not advise anybody who has got anything less than a five-year or seven-year time frame to invest in a small cap irrespective of what the last one year’s performance has been.

In fact, in the current situation, it is more of a problem because you are not sure of whether the valuations are correct to be paid at this point in time. There's too much of a macro overhang and that can definitely have a stronger impact, probably, if markets have to move southward.

The bigger challenge that I see on the small cap side is actually the AUM of the fund. All of us know that everybody keeps kind of moving on to a fund that has been performing and the AUM keeps increasing.

Let me give an example of the two funds mentioned – Nippon Small Cap and Quantum. Now both these funds started in 2013, so they have a good eight-nine year-old history that you can go back to and see if the funds have done well.

If you look at the returns of the funds, both have done really well. Nippon is today managing close to Rs 19,200 odd crore worth of AUM, as of March 31.

If you look at the 251st stock, which by SEBI definition gets categorised as small cap, the market cap of that stock is almost as good as the AUM that the fund is managing. Now, because of that problem, you will see that so much of AUM does not get deployed in the small cap space.

Nippon has 141 stocks in which they have invested precisely for this reason because they can't do investing of Rs 19,000 crore in small caps.

The exposure to small cap is only 45% of the total portfolio because you have the leeway to move around in large cap and mid cap. They only have 45% investment in the small cap and this is actually a problem across all small-cap funds, atleast on the performing side of the stocks.

If you look at Quant, it has moved up aggressively. They've been able to get there over the last one-and-a-half years because of the performance, but they're still close to Rs 1,600 odd crore worth of AUM. In terms of AUM, Quant is in a much better position than probably Nippon.

They are only managing 56 stocks because of the kind of money that they have to deploy. They don't really have to go and gather 150 stocks. If you look at the exposure to small cap in Nippon, it is 56% which probably is the highest in most of these funds that we are discussing today.

Talking about a small cap fund where you want the fund to take exposure to small caps, lower AUM, higher exposure to small caps and a lower turnover ratio probably works well. So, I would not mind looking at Quant Small Cap as well.

Amol, any thoughts on this? The AUM for Nippon is certainly high. Does it become difficult for them to outperform in the times to come or do you disagree?

Amol Joshi : Kirtan is absolutely right in bringing size into the mix. In fact, I have also asked this question not just about the small cap space but also in large cap.

One of the senior-most CIO has faced this question for the last decade, and he has presented data saying that in India, the fund sizes themselves are so small. Small cap could be a slight exception because you have to invest into 251st and up to 500 stocks only. To cut a long story short, till the time the fund has been able to manage, investors should probably overlook that factor.

We have a long way to go, and we have seen with market capitalisation and new companies coming into the picture, fund managers will have the investment universe to deploy the funds.

We have also seen small-cap funds stopping subscriptions. If the tide were to rise, I would trust the judgement of the Nippon equity investment team to probably halt the subscription till the time they do not find fresh opportunities.

Small cap investing is largely perceived to be high risk and gold investing low-risk. Should people invest in gold through the mutual fund and ETF route? For people who want to pure-play invest in gold, should they choose a gold ETF or gold fund?

Kirtan Shah: You should definitely have some exposure to gold. We have seen how Covid-19 played out when equity was falling and how, to a certain extent, initially, gold actually balanced out the portfolio.

Largely all of us understand that it probably gives you a balance in the shorter time frame. So, I am in for gold in terms of investment in a portfolio. Now for me, gold ETF theoretically low cost, and does not have an exit load. A lot of other things kind of work with gold ETF.

But I think it is meant for savvy investors and not for a retail investor.

The biggest advantage of a gold ETF apart from the cost is to be able to time the market. So while you're trying to buy gold ETF, you can buy it within live markets, and can pinpoint on a price at a particular time that you really want to buy it.

In Fund of Fund category, like HDFC Savings Fund or any other gold fund let's say, what it does is it gives you the end of the day.

One of the key reasons why a lot of savvy investors want to do ETF investing is not for the cost but the ability to be able to time the market, which adds a lot of value which the FoF can't bring on the table.

But this is a big disadvantage to retail investors because you really need the ability to be able to time the pricing of buying and selling at the first instance.

The second is the illiquidity because of which there is a huge pricing gap. So, even if the fair value is 100, it is not necessary that you get the ETF at 100. Even if there is a 15-basis point extra cost in the FoF, you might easily lose out much more than point five, if there is this liquidity gap because of which the pricing is not correct which is very common in our markets.

If you are a savvy investor and can understand timing, being able to buy this from the market, understand the illiquidity gap, or if you have a higher volume, because of which you can reach out to the AMC and create your own units, you can go for ETFs.

For most other retail investors who want to systematically accumulate gold and want to do SIPs, gold FoF is a better proposition than a gold ETF.

Amol, what is your thought about whether people should do this and which route is better?

Amol Joshi: You should have some allocation to gold and precious metals. This goes hand in hand with what most planners, advisors, and distributors would tell you. It is proven by empirical data as well that the prime driver of portfolio returns is asset allocation and not security selection. So, precious metals, gold as well as international equity are diversification tools and allocation assets to core equity and debt portfolio. You should have investor exposure to gold.

ETF, by its very nature, you have to buy from stock exchanges. So, not every mutual fund investor has the demat and trading account. If you want to essentially buy ETFs, you should make the effort of opening a demat and trading account, which adds to your overall costs and administrative hassle.

Most of the old school brokers do not have the ETF SIP or stock SIP or ETF SIP kind of concept. Their systems are simply not capable of that.

We have seen last month that SIPs have touched the all-time highest contribution from investors. It is not unrealistic to assume that investors would want to take gold exposure as well via SIP route.

Given all these constraints that ETF has including the non-transparent price discovery, most of the times it will be against you.

When you are a buyer, you will get to buy ETF units at premium. When you are a seller, you will have to sell it at a discount. That's exactly how nontransparent discovery works. Given all these reasons, most laymen investors would do better investing through a gold savings fund as compared to an ETF.

Amol, tell us what are the options available?

Amol Joshi: You have options like the Gold Saving Fund, which is nothing but a fund that invests fully into Gold ETF. Your actual underlying is exactly the same. Only the product wrapper or product construct differs. Every AMC and definitely the larger ones do offer Gold Savings Fund as a product, including HDFC and ICICI. You can simply choose within ETFs.

Pricing or the expense ratio is one of the important criteria that attracts many people towards the ETF.

Just keep it simple. Choose any of the Gold Saving Funds where you find the lowest expense ratio within the product. There are other factors that you should look at, but expense ratio – since the underlying is the same – is probably the most important. A couple of options that I have already shared with you – ICICI, HDFC, Nippon and SBI, all of these AMCs do have a Gold Savings Fund. You can look at probably the HDFC Gold Saving Fund.

Kirtan, your thoughts on the components?

Kirtan Shah: While you're trying to choose any fund – he has already named HDFC – along with the expense ratio, there is another component called the tracking error that they should look at. That can give you a slight edge on selecting the right fund. Choose any fund which has the lowest tracking error and the lowest expense ratio.

Of course, the tracking error is an element of the ETF, but because ETF is the underlying, your FoF is going to drive the same returns that the ETF is going to drive.

You are saying that the investor when they want to choose the fund should look at the lowest tracking error of the underlying ETF if they are using an FoF mechanism?

Kirtan Shah: Yes.

Both our experts believe that gold should be an integral part of the portfolio. Can you tell us whether there would be any issues if investors have exposure in any of the Invesco MF schemes.

Amol Joshi: Our regulator and authorities are already on the job. If there was something exceptionally wrong, a big red flag, then we would have heard from the regulator. But I want to look at it from a different point of view.

I would like to take you back to April 2020 when mutual funds, in general, and debt mutual funds in particular, probably faced their biggest acid test and biggest shock in history, as well as over any period that we have been working in mutual funds.

What happened one-and-a-half-year later, investors recovered 100% of their monies, and there are still some payments to be made from six wound-up schemes of Franklin Templeton Mutual Fund – all of them into debt and credit category.

Mutual fund has a very well-defined regulatory structure where you have a trustee, a board and independent fund management teams.

It's good news that there has been a whistleblower who has been able to put out some facts which were not in line with the regulations.

As things come out in the open, mutual funds, not just Invesco but the overall ecosystem, will only get stronger, the way all of us, debt mutual funds again in particular, got stronger after the scheme's winding up scenario.

I would say not to jump the gun for the simple reason that when everybody dashes towards the exit door, hardly one or two or five can exit while the remaining people get trapped inside.

That is precisely something that happened in the winding-up case where the AUMs rapidly declined, and then extreme measures had to be taken on the fund manager’s side. So, I would wait to hear from the regulatory authorities instead of jumping the gun.

Kirtan, what about you? What are your thoughts?

Kirtan Shah: We should not create panic because these allegations are not proven yet. But from whatever I read from the media, I understand that the whistleblower was an ex-fund manager. Coming from somebody like him, I would not completely ignore the fact that there cannot be something material in this.

If you look at the third allegation, which is the inter scheme transfer, securities like DHFL were transferred to offshore PMS (portfolio management services). We have seen this happening even during the crisis where debt funds moved their schemes to Balanced Advantage Fund category. This is absolutely not wrong in legal structure or the way it is meant to work. But it just goes to show how that particular AMC wants to run the show. So, this is not a structural problem but more to do with how a particular AMC believes in a process.

In such a situation, where you have got so many options available, a lot of us would not want to risk our necks and move into investing with a particular AMC.

Of course, nothing is proven. We are not talking about anything that has really gone wrong legally, but it is more to do with an investing process than anything else.

Let’s talk of the kind of numbers that came out on the debt side in the recently released AMFI numbers. While some numbers like the SIP numbers looked okay, on the debt side, there was a fairly large number that came out. Why did such large exits happen from the debt portfolio?

Kirtan Shah: If you break down the numbers, there was some Rs 1.14 lakh crore worth of redemptions that happened on the debt side. Out of that, close to Rs 57,455 crore was liquid and overnight. This is very common and acceptable because it was year-end and quarter-end. You would have treasury balance, treasury selling to prop up the balance sheet. So, Rs 57,455 crore does not require a lot of explanation.

The other part is probably the popular categories where a lot of us invest, which is the Corporate Debt Fund or the Banking PSU or the short-term Debt Fund, which probably saw Rs 29,000-30,000 crore worth of reduction.

This is a discussion area which is happening because the yields are extremely low. Inflation is moving up, yields are not exponentially going up. And if it is going up, it is hurting the NAV in some fashion. There is so much expectation that the rates will go up, but we have not seen RBI move the gun. RBI is trying everything possible to suck the liquidity out of the system, but the rates are not going up. So, I think there is a lot of overhang on where and how the rates are possibly going to move. That is one reason why this redemption could really have triggered.

Amol, what are your thoughts on this?

Amol Joshi: In the first month of the quarter, we always have last quarter’s data available to talk about. Treasury redemption is a feature, not a bug.

During quarter end on 15th, you also have advanced tax payments, and that's where your liquid cash comes in handy.

You will have seen a slight uptick, especially from the smaller banks, where FD rates have slightly gone up with expectation that inflation is going up and the rates are about to harden.

Some of the people especially during the quarter-end time, to freeze all the yields that are available on the banking side, probably would have taken money off the table.

On the retail side, it will not move the needle much, but we cannot ignore it at the same time.

March is also the month where you saw extreme movements in the equity market. So, some investors who had money in the shorter-term funds, those investors actually switched or fast forwarded their STPs to take the lump sum exposure. That is also one of the contributing factors.

Hitherto, mutual funds were giving competition to banks on the fixed income side. I hear of this concept of Neo banks, which are giving interest rates as high as 7%. Why shouldn't an investor choose those or arbitrage funds or short-term funds, which may give slightly better returns than FDs, but certainly lower returns than what the Neo banks are giving?

Amol Joshi: Favourable tax treatment. If you hold debt mutual funds for more than a three-year period, you will get the benefit of indexation. Post indexation, your tax outcome will be substantially lower. That’s as a significant advantage that you cannot overlook.

Kirtan Shah: If you really want to park a small part of your portfolio, I will want to choose the Neo bank because you said 7%, but there are options which gave 8% and 10% to a microfinance loan.

If you park a small amount of your money there, it is as liquid as anything else. You get that money in two days. A small portion can definitely be taken as an exposure provided the investor understands the risks. It's a new platform so you have to understand that risk. But there's no comparison of the return that they are giving versus what money markets are making right now.

But the Reserve Bank guarantees up to Rs 5 lakh?

Kirtan Shah: That's with fixed deposits but if you take a BharatPe or a liquid loan kind of structure, nothing is guaranteed. Individuals have to understand this.