In the last 10 years, some unknown stock names have delivered a whopping 90-100 per cent CAGR. Many such companies are extremely small and under the radar of sophisticated investors/fund managers. Welcome to the world of microcaps. Given the extended bull market in the country’s stock market, many investors are searching for high returns and thus going up the risk curve. In this backdrop, Motilal Oswal Asset Management Company’s (MOAMC) launch of the Motilal Oswal Nifty Microcap 250 Index Fund is interesting as it will provide investors with a conduit to play the microcap stocks through the low-cost index fund route. This is also the first such offering. New products do add a whiff of fresh air, but investors need to understand the pros and cons of microcap investing. Here is a lowdown.

What are microcaps

Microcap companies are stocks that are beyond the first 500 listed stocks (by market capitalisation). These stocks have smaller m-cap and are under-researched and under-owned. These are among the reasons why the stocks have the potential to give out-sized returns. For instance, many of the best-performing stocks in Indian market are microcaps.

Unlike largecaps, midcaps, or even smallcaps, microcaps suffer from some unique problems. One, many microcaps have a dependence on key individuals, resource constraints and a limited range of products/services. Two, microcap stocks are the most illiquid due to less number of investors trading them. Three, microcaps have historically seen drawdown for a longer period than even smallcaps; this means when microcaps fall, they tend to stay down for a longer period of time.

Nifty Microcap 250 index

About the index: NSE Indices has developed the Nifty Microcap 250 Index, which aims to track the performance of microcap stocks listed or permitted to trade on NSE. The index includes the top 250 companies beyond the Nifty 500 index constituents, selected based on their average full market capitalisation. A stock’s weight is based on its free-float market capitalisation. The index is relatively new, having been introduced in May 2021. Index stock replacements are high in this basket. So, turnover could be higher for index funds.

Index fund cost: The Motilal Oswal Nifty Microcap 250 Index Fund will replicate/track total returns of Nifty Microcap 250 Index. The NFO period commenced on June 15 and shall close on June 29, 2023. The indicative total expense ratio for the regular plan of index fund is 1.00% and that for the direct plan is 0.40%.

Top holdings: As a passive investor of an index, the constituents do not matter much because the index will semi-annually rebalance itself. Still, the current top holdings of the Nifty Microcap 250 index are Religare Enterprises, Karnataka Bank, Ujjivan Financial Services, Procter & Gamble Health, Reliance Power, Usha Martin, South Indian Bank, Ramkrishna Forgings, Reliance Infrastructure, and Ion Exchange (India). Do note that two of the microcap index holdings are Reliance Power and Reliance Infrastructure that have been wealth destroyers in 5-year and 10-year basis.

Tracking error: It is more important whether the index fund is able to track the parent index well. Since Motilal Oswal Nifty Microcap 250 Index Fund is a new scheme, there is no record of tracking error (annualised standard deviation of the tracking difference of the index fund). But investors should remember that the tracking error of index funds replicating Nifty Microcap 250 could be higher than a typical Nifty 50 index fund as the former is likely to face greater problems in buying or selling underlying microcap stocks. An internal study shows it takes close to 3 days to trade 100 crore, as per MOAMC.

Too diversified: For an index with 250 stocks, there is a case of over-diversification. While many argue that a higher number of stocks reduces the overall impact in case of stock failure, how much protection is required? One can then use the same logic and add 300 stocks to an index and argue this is a better offering. With 250 stocks in an index, the implication on the portfolio is also low when you have multi-baggers --- which is the ultimate motive of microcap investing. The biggest weight and 10th biggest weight in Nifty Microcap 250 Index have 1.5% and 0.93% exposure. The more you go down the weight spectrum in this index, the more miniscule is the allocation.

Related Stories
SBI Small Cap Fund: Should you invest?
SBI Small Cap has been performing consistently since its inception in 2009
Risks to note

Microcaps can destroy wealth as quickly as they create it. Therefore, the best time to enter microcaps is when broad markets are in the doldrums and microcaps are entirely out of favour. There’s a scramble for the next big multi-bagger stock in microcaps. For instance, Nifty Microcap 250 Index has gone up 45 per cent in last 1 year, almost twice the rate of 23 per cent gain for Nifty 50.

A high number of microcaps have seen sharp rallies, so much so that the market regulator, SEBI, and exchanges have introduced enhanced surveillance mechanisms for companies having a market cap of less than ₹500 crore. The enhanced surveillance mechanism (ESM) framework is effective from June 5, 2023. In short, enhanced ESM will be applicable to microcaps that will be rising too fast too soon.

The best time to buy microcaps is probably when they’re trading at steep discounts to midcaps and largecaps and the market overall. As on June 19, the price to earnings of Nifty Microcap 250 was 25 times, a premium to Nifty 50, Nifty 500, Nifty Midcap 100 and Nifty Smallcap 250.

The above risks can be dealt in some way by using the SIP route to invest in microcap index funds.

Our take

Motilal Oswal Nifty Microcap 250 Index Fund is a novel offering. If you want to add this to your portfolio, maintain 3 cent allocation. Use the SIP route to invest, instead of taking lumpsum route. Book profits in case of outsized gains

We believe that active fund management in microcaps could offer a better solution, given the risks. There are many reasons why only 3-4 per cent of mutual fund industry is invested in microcap stocks. Active fund managers are highly aware of such risks. A passive structure like index fund does not completely address the problems of getting into dubious and operated stocks which can destroy your wealth in a blink. Many large and prominent scam/fraud-hit stocks have been part of indexes. You can wait for actively managed microcap funds to come.