The Hindu Business Line : Small-cap, big gain

SUNDARAM Mutual Fund's proposal to start a small-cap fund may well trigger a spate of such offers from other fund-houses. Such a fund is a good investment proposition for retail investors because small-cap stocks provide high returns. The attractiveness of small-cap funds will, however, depend on three factors. One, small-cap stocks need to be clearly defined. Two, small-caps should not be managed as open-end funds. And, finally, a small-cap index needs to be constructed to benchmark risk-adjusted returns.

Defining small-caps: Typically, these are stocks that have a market capitalisation of less than Rs 500 crore. Defining small caps narrows the universe of stocks that such funds can invest in. This helps investors carefully build their investment portfolio. A discerning investor may, for instance, buy units in large-cap index fund, mid-cap active fund and a small-cap active fund. If small-cap stocks are not clearly defined, the small-cap fund may also be investing in the same stocks as the mid-cap active fund. Such a portfolio construction could subject the investor to high risk, with over-exposure to certain stocks.

Exit option: Fund-houses prefer open-end fund as it gives easy exit options to the unit-holders. But small-cap open-end fund may not be an optimal choice. The reason is that the continual entry and exit of investors will increase the fund's impact cost. This refers to the cost due to change in market price because the fund buys or sells large quantity of shares.

The average impact cost for Nahar Industrial Enterprises, for instance, is 3 per cent. Suppose this stock trades at Rs 100 when a small-cap fund places an order to buy, say, 1,000 shares. The fund can expect to buy the shares at an average price of Rs 103 and not Rs 100 because its demand for the shares would have pushed up the price.

Similarly, a small-cap fund wanting to sell, say, 1,500 shares can expect the stock to decline on an average to Rs 97 because its supply of shares would have pushed down the price. The impact cost will, therefore, have a negative effect on the unit-holder returns. Such cost will only increase if the fund has to continually adjust its portfolio due to purchase and redemption of units.

Besides, the portfolio construction of an open-end small-cap fund may be sub-optimal. Because the fund has to meet redemption requirement every day, the portfolio manager will have to invest in small-cap stocks that carry higher liquidity. Typically, liquidity and returns are inversely related. That is, higher liquidity leads to lower returns. So, an open-end small-cap fund may generate lower returns because it is forced to hold liquid stocks among the small-cap universe.

Fund-houses should, hence, offer small-caps as an interval fund. Such a fund would be open for purchase and sale of units for fixed number of days at periodic intervals, say, two days every quarter. This reduces the impact cost and yet provides unit-holders an exit option.

Benchmark: There is always a tendency for fund-houses to report absolute returns. The better measure to judge a portfolio manager's skill-sets is to benchmark such return against an index with similar risk characteristics. It also helps investors in their decision making process. Investors normally choose among small-cap funds based on the peer performance. The best way to compare small-cap funds is to look at their risk-adjusted returns vis-à-vis the benchmark return.

Benchmark index also serves as a measure to check if the fund is justified in charging high management fees. Suppose small-cap index returns 20 per cent and an active small-cap fund generates a gross return of 25 per cent, investors may be justified in questioning a management fee of, say, 2.5 per cent. The returns from active investment will then be just 22.5 per cent, and perhaps less on a risk-adjusted basis. If funds are unable to beat the index after deducting management fees, there may be a case for small-cap index funds. And that is possible only if the market has a well-constructed small-cap index.

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