Small-cap funds: High on cash, low on ideas

The hardest thing to believe about small-cap funds, the category of mutual funds that has received the maximum inflows in the last 12 months (it has got a cash injection of a whopping Rs 24,000 crore), the category of mutual funds that has delivered the highest returns over a 10-year period, and the category of mutual funds that is benefiting from the Indian markets scaling all-time peaks this week, is that they have a problem. A problem of scarcity. Let's explain why.

The winner's curse

As the name suggests, small-cap funds primarily invest in small-cap stocks. But finding a 'winning' small cap can be a slog, like finding a needle in a haystack.

Even when a mutual fund does find a "winning' small-cap stock, there is a point up to which it can invest. Because the more money the mutual fund puts in that stock, the higher its price and valuation go - two compelling reasons that push the mutual fund to start shopping for another 'winner'.

This big wheel of investors putting their money in the mutual fund and the mutual fund's pressure to find a 'winning' small-cap stock stays on loop until such stocks become a dying breed.

This is where small-cap funds currently find themselves in. Or at least they think they are moving towards that zone.

Shut shop, pursed lips

Tata Mutual Fund is the first fund house to bite the bullet. It has decided to temporarily suspend all fresh investor inflows through lumpsum and switch-in applications for Tata Small Cap Fund from July 1. (Existing SIPs and STPs have been spared for now).

Another hotshot fund manager, who presides over a very popular small-cap fund, raised the alarm regarding the flows into the small-cap category.

"Given the money that has flowed into small-cap funds in the last year, it is huge. Now the valuations of several stocks on our radar are turning out to be very high. Given the situation, we can't just go on and deploy the money. In the small-cap segment, we are not getting any ideas to invest due to the high valuations of the stocks," said the fund manager on condition of anonymity.

What you should do

If you are a long-term investor in small-caps through SIP, we'd suggest you remain disciplined.

If you plan to invest a large lumpsum in small-cap funds now, we suggest you exercise caution. Looking at small-cap funds' historical performance (see the graph below), you can see that a bout of underperformance is not too far behind a period of eye-catching returns.

Lastly, suppose you are unable to curb your enthusiasm and find it painful to see fellow investors plough more and more money into small-cap funds. In that case, we'd like to remind you what Warren Buffett, the Oracle of Omaha, once said: "Only when the tide goes out do you discover who's been swimming naked."

Suggested read: These small-cap funds have high large-cap exposure