Why Avoid Small Cap Mutual Funds

Mutual funds are largely retail investment products.They are more suitable for saving money rather than make it grow at astonishing rates.They are largely targeted at middle class investors.However wealthy investors too continue to invest in mutual funds.The advantages of getting professional investment management and not  having to deal with researching stocks , trading and tracking a portfolio is too much to give up. However mutual funds investing exclusively in small cap companies are not very popular with more sophisticated investors.This is because mutual funds are not the best way to invest in small cap companies.

Consider this: There are 62 funds in Value Research’s Mid and Small Cap category. Of these, no more than six are either exclusively or primarily focused on small-cap stocks. These funds have had a patchy performance with a large amount of volatility and have been unable to give attractive returns even over relatively long periods of time. Of course, volatility is a given in any small cap portfolio because smaller companies tend to react violently to any change of mood. However, the whole idea is that the investment manager will eventually be able to build a decent base of investments in a set of small-cap companies that are on their way to growing out of the category and into being mid-cap companies. Here lies the problem. If a knowledgeable and expert investor were to do this directly, he would probably identify a handful of companies and then would slowly build positions in them.

This would have to be done slowly because by definition, these companies have low capitalisation and are thus likely to have low trading volumes and probably low floating stock as well. This, in turn, means that the impact cost of trying to buy a large chunk of stock too quickly could be quite high. The investor would have to understand that the same rules apply if he wants to exit the stock in a hurry.

These stocks are not liquid, and when the time comes to realize returns, the investor could again have to wait for a long time to encash his investments. Just as the investor did when buying into the stock, the selling would also have to be done in dribs and drabs. If that isn’t done then again, the impact cost of selling to much stock too quickly would itself depress the price. This is particularly true when markets take a sharp turn downwards.

In such situations, many small-caps are not sellable at all. What this means is that the investor must be truly convinced by a small cap stock to hold it through a trough and (hopefully) to a later peak. If an investor  wants his stocks to provide quick liquidity, then small-caps are not for him. All these characteristics of small-cap investing means that there’s a very poor match between the requirements of investing in small cap funds and the way mutual funds need to operate. Mutual funds need to be liquid, they need to invest in relatively large chunks, and their investors tend to be sensitive to sharp volatility.

What’s worse, whenever the NAV drops sharply, a certain proportion of fund investors tend to redeem their investments in a rush. These redemptions are precisely what small-cap funds can’t handle at that point. In a general downturn, all these effects—NAV decline, loss of liquidity, impact cost of selling tend to multiply with each other and produce a huge negative impact.So even if a sophisticated investor who understood all  the issues involved  is willing to play the long game, his fellow investors are unlikely to do so.

Small-cap investing is an inherently tricky activity. It is suited only to investors who are knowledgeable, patient and don’t mind paying a percentage game.For this purpose a person needs a large portfolio and the willingness and discipline to hazard only a small part of it.