Growing size of small-cap MFs should worry you | Economic Times

Small-cap equity funds are enjoying a strong run. However, with stock prices moving up sharply, some funds have grown considerably in size. Can a burgeoning asset base pose a problem for these funds?A few small-cap funds have seen their sizes balloon. Nippon Small Cap and HDFC Small Cap now run assets in excess of Rs 10,000 crore. SBI Small Cap is also approaching Rs 8,000 crore in assets. So what is the big deal, you may ask? For the nature of the market segment these funds operate in, a large size can become a noose around the neck. The small-cap universe is a big arena—all stocks beyond the 250th company by market capitalisation fall under the ambit of small-cap funds. However, the investible ideas within this basket are very few. The actual hunting ground for fund managers is restricted to a few quality companies backed by strong fundamentals and enough market liquidity.Now, this is where the size constraint comes into play. Faced with a growing asset base, these funds can either park incremental flows in more stocks or in the existing names. The first option is worthwhile only when valuations in the broader market are sanguine, making the risk-reward more favourable. Further, exploring lower down the market cap ladder in this space is fraught with risk. Alternatively, fund managers may choose to invest higher up the market cap spectrum to fill the void—in mid-cap or even large-cap stocks.However, the room to maneuver is restricted as rules permit funds to park not more than 35% of the portfolio beyond smallcap names. Kirtan Shah, Chief Financial Planner, Sykes and Ray Equities, observes, “Fund managers no longer enjoy much leeway in allocating money after introduction of strict asset allocation rules.” Fund managers cannot simply keep adding to existing positions beyond a point either.Small-cap funds have grown in sizeMost of the expansion in fund size is owing to uptick in NAV. Rapid growth in asset base due to inflows may affect fund performance. 82855388As these funds grow in size, maintaining the portfolio quality and liquidity will become difficult. On a large asset base, taking meaningful exposure (say around 4-5%) in individual bets carries high impact cost. When liquidity dries up in small-cap names—which tends to happen very quickly—exiting these positions also proves tricky. In the event of heavy redemptions, fund managers may be forced to dump stocks at throwaway prices. Kaustubh Belapurkar, Director Manager Research, Morningstar Investment Advisor India, feels there is no cause for concern as of now. “Tackling large, illiquid positions can become a challenge at time of exit, but most small-cap funds appear comfortably placed in terms of liquidity.”In such circumstances, fund managers end up spreading assets thin across stocks or investing in larger sized companies or both. Look no further than the largest fund in this segment—the Rs 13,085 crore Nippon Small Cap currently runs a portfolio of more than 120 stocks. Samir Racch, Fund Manager – Equity Investments, Nippon India Mutual Fund, explains the multiple bite-sized positions in the fund: “The portfolio tail tends to become longer in a bull market as sharp price upswings deter scaling up of initial positions. Besides, we take the ‘foot in the door’ approach in smallcaps— start with small initial investments in the target stocks and gradually build positions till we feel comfortable.”Experts point out that this can eventually lead to dilution in the funds’ return profile. Fund houses are acutely aware of the difficulties managing flows into this segment. A senior fund manager admits, “Our small-cap fund is currently seeing substantial flows through monthly SIPs. If not for the concurrent redemptions, absorbing these flows would have been a challenge.” Imagine a fund manager expressing relief over outflows!Essentially, small-cap funds’ capacity to absorb flows beyond a point is fairly restricted. In the past, several small-cap funds have resorted to gating flows to tide over size constraints. Last year, several funds like DSP Small Cap Fund and Nippon Small Cap Fund reopened to lumpsum investments after having restricted them earlier. Interestingly, SBI Small Cap closed itself to lumpsum investments in September 2020, barely five months after it had also reopened to them. It currently permits SIP only up to Rs 25,000 per month. “In this space, fund houses do keep an eye on capacity and have shown willingness to shut the tap if capacity becomes a constraint,” remarks Belapurkar.For now, problems still seem a mile away for these funds. Bulk of the rise in AUM can be explained by the uptick in fund NAV itself. Investor flows into these funds have actually been tepid, even negative in some cases. But if investors start piling on to small-cap funds attracted by the blockbuster performance, these issues will crop up. Beyond funds gating the flows themselves, investors may keep an eye out on the pace of inflows in coming months, warn experts. Shah insists, “At any point, if money starts flowing in spate into these funds, it is a red flag. We have seen enough instances in the past of fund performance slipping after sharp rise in the AUM.” He adds that investors should not get attracted by the near-term performance and limit exposure to the small-cap segment.