Micro-Cap Funds: Are they the next wealth creator or a potential bubble in the making? Here's a lowdown!

Micro-Cap Funds: Are They the Ideal Choice for Retail Investors?

Wherever the tides go for a particular segment of stocks, or a new sector is born out of innovation or technological breakthrough, we are bombarded with a lot of positive news on the same. It's the talk of the town, a favorite subject of discussion at various gatherings, parties, and business forums. Ask anyone in the markets, and you will hear the same tune: these are the hot stocks. And, there should be no prize for guessing that the hottest stocks are often from the micro-cap category.

The Micro-cap segment of the equities market has been capturing the imagination of investors and mutual funds alike, riding high on a strong rally in the broader markets and the increasing risk appetite of retail investors. It would be quite surprising if anyone has not been lured by this trend, as many stocks have experienced meteoric rises over the past year or so. Just take a look at the Nifty Microcap 250 index, which has surged nearly 53 percent in the last year alone.

But what exactly are micro-cap stocks? In a world where there are over 5,000 companies listed on the BSE (Bombay Stock Exchange) and more than 2,000 companies on the NSE (National Stock Exchange), it's crucial to understand where these tiny giants fit in. SEBI (Securities and Exchange Board of India) defines Large-Cap stocks as the top 100 stocks in terms of market capitalization, Mid-Cap stocks as those ranking 101st to 250th, and Small-Cap stocks as those ranking 251st onwards.

Micro-cap stocks, they are generally considered as companies ranking beyond the top 500 in terms of market capitalization. These companies typically have a market capitalization of less than Rs 5,000 crore. Now, enter the Nifty Microcap 250 index, designed to track the performance of micro-cap stocks listed or permitted to trade on NSE. This index includes the top 250 companies beyond the Nifty 500 index constituents, selected based on their average full market capitalization. A stock's weight in this index is based on its free-float market capitalization.

However, what's truly fascinating is the growing interest from mutual funds in the micro-cap space. While Micro Cap Funds do not currently have a separate sub-category under equity mutual funds, the recent rally has drawn some mutual funds toward this segment. They are eager to capitalize on the opportunities that lie beyond small-cap stocks.

In June 2023, Motilal Oswal Mutual Fund made history by launching India's first passively managed scheme, the Motilal Oswal Nifty Microcap 250 Index Fund. This innovative fund offers exposure to micro-cap stocks, tracking the Nifty Microcap 250 - TRI index, which invests in stocks ranking 501st to 750th in terms of market capitalization. As of August 31, 2023, the fund had already attracted Rs 324 crore in investments.

The top 5 holdings of this fund include Religare Enterprises, The Karnataka Bank, Ramkrishna Forging, Ujjivan Financial Services, and Usha Martin.

Not to be outdone, Bandhan Mutual Fund has also recognized the potential of the  micro-cap space. Recently, they filed initial papers to launch the Bandhan Microcap Fund. This fund's objective is clear: to provide long-term capital appreciation by predominantly investing in equity and equity-related instruments of micro-cap companies.

However, before diving headfirst into micro-cap investments, it's essential for investors to be aware of the associated risks. While all equity investments carry a degree of risk, micro-caps add an extra layer of complexity and volatility. These tiny stocks are susceptible to daily price fluctuations driven by both micro and macroeconomic factors. Liquidity can also be a significant concern, with trading volumes, settlement periods, and transfer procedures potentially restricting the ease of buying and selling.

Furthermore, those considering SIPs (Systematic Investment Plans) in these schemes should note that AMCs (Asset Management Companies) may halt SIPs altogether in the face of higher downside risk. In the short term, these high-beta stocks can offer substantial returns during bullish phases but may plummet to new lows and become illiquid during bearish market conditions.

So, does this mean one should avoid micro-cap schemes altogether? Not necessarily. Just like small-cap funds that gained traction in the past, micro-cap funds are likely to become more popular among investors. Depending on an individual's risk appetite, a small allocation to these schemes can indeed enhance returns and potentially help investors achieve their financial goals faster.

Kirtan Shah, Co-Founder & CEO of fpaeductech, provides valuable insight by reminding us, "Average daily turnover in the micro-cap index is 5 crore, and the free float of micro-cap stocks may not be entirely free, hence liquidity is a big challenge for investors in this space. This is surely meant for seasonal investors who understand the risk-return proposition. Retail investors should not get carried away looking at the last 1-3 years of returns from this space."

In conclusion, the world of micro-cap stocks is a dynamic and potentially rewarding arena for investors, but it comes with its fair share of risks. With the right understanding, strategy, and risk management, investors can navigate these turbulent waters and potentially reap significant rewards. As more mutual funds enter this space, it's evident that micro-cap stocks are here to stay and may well become the hottest topic of discussion in the financial world.

Disclaimer: The article is for informational purposes only and not investment advice.