Problem of plenty: Why flows into small-cap funds hit a record high in June

Investors are betting on small-cap stocks amid a surging stock market as inflows into small cap equity mutual funds touched a record high of Rs 5,471.75 crore in June even as some other categories of equity funds witnessed net outflows, according to the data released by the Association of Mutual Fund (AMFI).

In May, total inflows into small cap funds stood at Rs 3,282.5 crore. Point to note: Investment in small-cap mutual funds is associated with higher risk lcompared to large and mid-cap funds as they invest in lesser-known and under-researched companies.

“People are withdrawing money from large cap funds and trying to put it back in the small cap fund because they find that there is a potential to make more gains in the small cap funds,” said N S Venkatesh, Chief Executive Officer (CEO), AMFI.

Overall, the combination of strong performance in small-cap stocks, the desire to participate in the market rally, and the resultant preference for mid and small-cap funds contributed to the massive surge in small-cap funds in India in June.
 

Valuation gap between small and large companies is high

"Since the last few months small-cap stocks have shown a tremendous outperformance. The major reason for this could be the valuation gap between small-cap companies and large-cap companies. This always happens when markets become a little expensive but the fund flow chases stocks. In such type of market, fund managers try to find out values or pockets of opportunities on a comparable basis that are available at the lower end of the radar. These stocks are with a low base and can grow at a higher pace compared to large companies in terms of percentage growth and are undiscovered stories. Hence higher risk equals higher reward. The massive fund flow via mutual funds, PMS or direct equity investors has added more momentum to it. If you see the performance of small-cap funds in the mutual fund space, the 5-year CAGR is around 18-21 per cent ,3 years at 40-45 per cent  and 1 year  at 30-37 per cent," said Mukesh Kochar, National Head-Wealth, AUM Capital Market.

Small caps have outperformed in a volatile market
In the last six to 12 months, small cap equity funds have  given a return of around 12-15 per cent on an absolute basis. When a fund outperforms, money is bound to chase it. 

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There has been a substantial rise in small-cap stock prices, with the Nifty Small cap 100 index gaining close to 15% returns in 2023, which is double of the benchmark indices Nifty 50 during the same period. This performance attracted investors to the small-cap category.
 

"Investors have been favouring mutual fund schemes that invest in the broader end of the market, including mid and small-cap funds, as there is also an underlying expectation that such broad-ends offer fund managers the opportunity to discover meaningful number of alpha generation opportunities. Most investors are seeking to participate in the rally and take advantage of the potential for high returns," said  Nirav Karkera, Head of Research, Fisdom.

"In times of economic recovery and general optimism, small-cap mutual funds generate better returns than their midcaps and large-cap peers. However, during an economic downturn, they could underperform. Since the market is surging, there is naturally a higher interest in small-caps," said  Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

Rs 17,869 crore poured into small cap funds in last six months
In the past six months of the year, investors poured approximately Rs 17,869 crore into small-cap schemes .Small cap funds received significant inflows, accounting for 27% of the total inflows till June 2023.

"This preference for small-cap funds reflects investors' confidence in the potential growth of smaller companies and their willingness to take on higher risk for potentially higher rewards," said Karera.

Data analysed by ICICI Securities  shows that the small-cap index has jumped 24 per cent since the end of March 2023. In the same period, the mid-cap index has gone up 22 per cent; the large-cap-focused National Stock Exchange Nifty50 Index has risen 14 per cent.

"Maintaining the trend of previous months, investors continued their maximum allocation to small-cap funds (Rs5,472 crore), trailed by value funds (Rs.2,239 crore) and mid-cap funds (Rs.1,749 crore). With large-cap stocks underperforming in H1CY2023 due to the notable valuation difference with the broader market-cap stocks, it was the right move by investors. For Q1FY24, the equity net flows were positive and strong, at Rs.49,918 crore," said Gopal Kavalireddi, Vice President - Research, FYERS. 

Watch Here: Is it time to sell mid, small-cap stocks?

Small-cap funds have witnessed substantial growth in asset size over the years. From May 2020 to May 2023, the assets under management ( AUM)  of small-cap funds in India surged from Rs 38,820 crore to Rs 1.54 trillion. In the last three years, 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. Seeing the double digit returns, investors have been deploying their investible surplus into small cap funds, particularly in 2023. 

 Venkatesh said investors are putting money in small-cap after being fully aware of the risk involved and many of them would have booked profit from large cap and focused funds to invest in small-cap funds for higher returns as small-cap index have crashed 60 per cent.

Case-in-point: Small-cap fund performance

Source: ACEMF, Fisdom Research Data

The problem of plenty

But this rush for small-cap funds have put fund managers in a tight spot and given rise to problem of plenty. In July, two fund houses — Tata MF and Nippon India MF — stopped taking lump sum inflows into their small-cap schemes, citing deployment challenges amid rising small-cap valuations.

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 that it is temporarily discontinuing lumpsum investment and restricted SIP transactions. Even SBI Mutual Fund has suspended lumpsum investments in its SBI Small Cap Fund since September 2020 and is currently accepting SIP investments up to Rs 25,000.

But why have these lumsum investments been stopped?

These step have been taken considering the recent sharp rally in the small cap space and increased investor participation through high ticket investments. As the AUM of a small-cap fund grows, fund managers find it increasingly challenging to effectively deploy the accumulated funds due to limited investment opportunities within the small-cap segment.

When fund managers  find the current valuations extremely high, they will have to deploy large sums at valuations without any considerable upside,  which will result in the  fund underperforming.  By halting lusum investments they can ensure valuations are not unreasonable.

"Several small-cap funds have implemented restrictions on lump-sum investments due to recent rapid rallies in small-cap stocks. These price surges have caused valuations to exceed their underlying fundamentals, raising concerns about overvaluation. Furthermore, small-cap stocks typically have lower liquidity, making it challenging to buy or sell large quantities within a limited price range. Exiting such stocks in bulk becomes even more difficult during market fluctuations. In the current scenario, these factors have created complex investment dynamics, prompting fund managers to impose restrictions on lump-sum investments to mitigate risks and ensure prudent portfolio management," said Anita Gandhi, Whole time director, head of institutional business, Arihant Capital Markets.

"Many smallcap fund managers seem to be viewing high-quality, investible opportunities in the small-cap segment as richly valued. For many, companies of choice are either overvalued or are more vulnerable to impact cost, or a combination of both. In such a scenario, heavy inflows only exacerbates the challenge to continue delivering robust risk-adjusted performance to investors,"  added Karkera.