#equityanddebtmutualfund

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Wish To Invest In Small Cap Mutual Funds? Read This!

XYZ is a great mutual fund scheme. It has delivered 35% returns in one year" “It is a 5-star rated fund with supernormal returns over the past year” These are phrases that are often used by commission-driven distributors to lure gullible investors. Sadly, investors blindly trust the superficial facts, without probing deeper. Over the past year, small-caps have generated a return in excess of 30%. Mid-caps and multi-cap funds trailed behind with a return of around 25%. Large-caps, known for their steady returns, delivered about 20% over the year. It is human tendency to trust products that have delivered spectacular past returns. Several studies in international markets have found sufficient evidence to conclude that retail investors often chase returns. This is why top performing schemes or even top-rated schemes of the past three to five years attract strong investor inflows. Due to this, assets of top performing schemes have more than doubled over the past 12 months. All it takes is that push distributors give, for investors to confidently put in more money, ignoring the underlying risks. In the small-cap category, burgeoning fund size fuels a liquidity risk. Small-cap stocks, due to their size, usually have a low trading volume. Due to the risks associated which such stocks, buyers often disappear in an unforeseen event. In such a situation, the fund manager may end up holding an illiquid stock or may have to sell the stock at a deep discount. At the end of it, your investment in the fund will take a beating. Certain fund houses have well understood this risk. To deal with it, certain mid-and small-cap schemes have restricted fresh investments. Fund houses such as DSP BlackRock Mutual Fund, Mirae Asset Mutual Fund, and SBI Mutual Fund have restricted inflows into their small-and mid-cap oriented schemes given the high valuations and liquidity risk. In most cases, lumpsum investments have been disallowed, while allowing investments only through Systematic Investment Plans (SIPs). To deal with the liquidity risk, other schemes are gradually shifting from mid-and small-caps to large-caps.

Thus, mid-and small-cap funds have the tendency to go from thrilling highs to dangerous lows. Funds that solely invest in small-cap stocks will incur higher risk. Investors need to be wary of the high volatility.

When considering other category of funds, you will notice that though large-caps are positioned well to deal with the market downside, the upside is limited. Hence, investors can expect stable and decent returns over the long term. On the other hand, multi-caps, which invest across market-caps, give the best of both worlds – The high-return potential of mid-caps and stability of large-caps. The return generated by the category falls in between large-cap funds and mid-cap funds. When investing in mutual funds, it is best to diversify your portfolio across market-caps and investment styles. Hence, though small-cap funds are risky, they should be a part of your portfolio in order to boost long-term returns — provided the funds conform to your risk profile and investment goals. But, before you invest in small-cap funds, you need to exercise due diligence. With over a decade of experience in fund research, PersonalFN has outlined important factors you need to look at before adding a small-cap fund to your portfolio.

Past Performance Do not rely on the recent performance of a small-cap fund or any mutual fund for that matter. You need to dig deeper and look at the long-term returns generated by the fund. Compare the returns of the fund with its benchmark and other peers across periods and market cycles. If the fund has consistently performed well across all market conditions and time periods, you may shortlist the fund for investment.

Risk-adjusted Returns There is no doubt that small-cap funds are risky. However, some funds are capable of managing risk better than other schemes. Hence, you simply should not ignore schemes that generate superior risk adjusted returns. By doing this, you may gain from the potential to generate solid returns with lower volatility when compared to similar schemes.

Portfolio Construction You may want to avoid schemes where the exposure is skewed to the top holdings. This concentration adds risk to already risky small-cap fund.  Choose funds that maintain an allocation of under-5% to each stock or where the weightage of the top 10 holdings does not exceed 50% of the total portfolio. You may also want to avoid funds that have an unproportioned exposure to large-cap stocks. Exposure to large-caps does help in adding stability and improving liquidity of the portfolio, but excessive weightage to large-caps could create a drag on returns when the market is trending up. Consider funds that maintain a proper balance.

Fund Manager Experience The experience of the fund manager plays a crucial role in the performance of small-cap funds. Unlike large-cap stocks that are well-researched and offer better corporate governance, small-caps may not always be sincere in their disclosures. It takes the experience of a fund manager to judge management quality and look beyond the numbers being reported. Although at times corporate frauds are well camouflaged, due diligence is necessary. It will be sensible to stay with a fund manager having extensive experience and a dependable performance track record.

Fund House Quality Investing in fund houses with multi-national names or those that are well-known in banking or insurance or other fields are not necessarily the best in mutual fund management. You need to pick schemes from a fund house with well-defined investment processes and risk management techniques. You can assess this by exploring how other equity schemes of the fund house have performed. If most of the schemes have generated a benchmark-beating performance across market periods, it is a sign that the fund house has put in place sound investment and risk management strategies. Thus, even if a star fund manager quits, it is likely that the fund may continue its stellar performance as the fund house follows a centralised management process.

An investor needs to prudently select the right mutual fund schemes keeping in mind the above points. This should be combined with factors like age, risk tolerance, investment horizon, investment objective, financial goals, and so on. It is difficult to predict when the market will favour large-cap or mid-cap, and small-cap stocks. So, as highlighted earlier, it will be prudent to include a mix of different categories of fund strategically in your portfolio. Given the current high valuations in the small-cap and mid-cap space, these funds may run into high volatility. An investor looking for lesser volatility or relatively stable returns can consider investing in large-cap funds or balanced funds. Those who are unsure about which mutual fund schemes to invest in may try PersonalFN’s unbiased mutual fund research services. Along with quantitative parameters such as performance, PersonalFN also considers qualitative parameters such as portfolio characteristics, fund manager experience, and fund house quality while analysing mutual fund schemes. We strongly suggest you subscribe to FundSelect Plus and benefit from the SEVEN time-tested, readymade equity and debt mutual fund portfolios. Based on your risk profile and investment horizon, you can choose out of three equity portfolios (Aggressive, Moderate and Conservative) and three debt portfolios. In addition, you get a readymade tax-saving portfolio as well. Don’t miss out… Subscribe Now!

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SEBI’s New Circular On Mutual Funds -- What Does It Means For Your Investments

The Securities and Exchange Board of India (SEBI) issued new norms in October 2017 to rationalise the process of classification of mutual fund schemes. Initially, mutual fund houses agreed with this decision, but changed their stance when they realised the difficulties in implementing the changes suggested by the capital market regulator. In response, the industry body—Association of Mutual Funds in India (AMFI) made representation to SEBIrequesting amendments to the newly issued rules. Taking a note of issues raised by the mutual fund industry and realising the practical difficulties in the implementation, SEBI amended the classification norms recently. As per the original circular issued by the capital market regulator, equity-oriented schemes were to follow the rules below:

Large-cap oriented schemes should invest at least 80% of their assets in large cap stocks

Large-cap and mid-cap schemes shall have minimum allocation of 35% in each

Similarly, mid-cap schemes and small-cap schemes shall invest at least 65% in mid-cap and small-cap stocks respectively

And here’s how the market capitalisation categories were defined:

Large caps: First 100 companies on full market capitalisation basis

Mid caps: All companies from 101st to 250th on full market capitalisation basis

Small caps: All other companies from 251st onwards on full market capitalisation basis

In the original circular, SEBI directed mutual funds to adopt the list of stocks the AMFI had prepared that classified them as large caps, mid caps, or small caps. Further, SEBI advised AMFI to adhere to the following points while preparing the list:

If a stock is listed on more than one recognized stock exchange, an average of full market capitalization of the stock on all such stock exchanges, will be computed;

In case a stock is listed on only one of the recognized stock exchanges, the full market capitalization of that stock on such an exchange will be considered.

This list would be uploaded on the AMFI website and it will be updated every six months based on the data as of on the end of June and December of each year. The data shall be available on the AMFI website within five calendar days from the end of the six months period.

Mutual fund houses argued that, these norms would potentially limit their choices while picking stocks for the portfolio. Moreover, some fund managers opined that the new norms will make them take higher risks. In the amended version of mutual fund classification rules, SEBI offered some concession by adding an additional point to the list above. The new circular says, “While preparing the single consolidated list of stocks, average full market capitalization of the previous six month of the stocks shall be considered.”

What are the Implications of SEBI’s mutual fund circular

Nothing will change significantly since the amendment, in this regard, won’t be considered in isolation, but will be an addition to the original provisions. Thus, it will only offer some more reaction time to the fund manager if any market movement disqualifies fund manager’s stock selection. Consider this example. The fund manager of a mid-cap oriented scheme bought 10 stocks about two years back which, due to market movement, have become large caps now and are resulting in the fund violating categorisation norms. Since the new amendments require AMFI to consider average market cap of last six months, the fund manager will not be stressed to sell them immediately.   Conversely, a large cap fund can make investments in such stocks only with a lag effect—this saves it from further flip-flops in buying and selling, which, in a way, is a forced decision made to comply with the classification norms.

Amendments in the provisions governing debt funds…

In the case of  ultra-short term duration, short duration, low duration, medium duration, medium to long duration, and long duration schemes, the ‘duration’ shall be considered at the portfolio level and not at the individual security’s level. Further, SEBI insisted on fund houses readily disclosing the indicative duration of the portfolio in the following manner. “An open ended XYZ scheme investing in instruments such that the Macaulay duration of the portfolio is between A to B years.” Moreover, fund houses are also required to explain the concept of duration and provide more information on it in the offer document. For medium duration funds and medium to long duration funds, the fund houses will have to mention tentative duration profile of such offerings under adverse market conditions. In this context, they will also have to note the reasons for deviating from the stated duration strategies, as and when they do. For example, indicative allocation of a medium duration fund will have to make in the following manner. Investment in debt and money market instruments will be made in such a way that the Macaulay duration of the portfolio is between 3 to 4 years. Portfolio Macaulay duration under anticipated adverse situation is 2 year to 4 years. The amendments have allowed corporate bonds funds to invest at least 80% in corporate bonds with a credit rating of AA+ and above. In the original circular, they were advised to invest at least 80% of their assets only in the corporate bonds of the higher credit rating. Similarly, credit risk funds can now invest at least 65% of their total corpus in corporate bonds rated AA and below (excluding AA+ rated instruments). Earlier, they were required to invest minimum of 65% of assets in bonds below the highest credit ratings. With the amendments, banking and PSU funds are allowed to invest in municipal bonds as well; previously, they weren’t. Moreover, floater funds can now invest in floating rate instruments by taking exposure using derivative instruments.

To sum up…

Amendments to the rules dealing with the categorisation and the rationalisation of schemes will offer flexibility to the fund houses. While fund managers enjoy more leeway in portfolio management, managing risk has become an even more critical function for the mutual fund houses. Greater disclosure norms, especially in case of debt funds, will make it easy for investors to select a fund. If you are unsure about which schemes you should invest in, we strongly suggest you subscribe to PersonalFN’s FundSelect Plus ------ comprehensive portfolio service ------ and benefit from the SEVEN time-tested, readymade equity and debt mutual fund portfolios. Based on your risk profile and investment horizon, you can choose out of three equity portfolios and three debt portfolios. In addition, you get a readymade tax-saving portfolio as well. Get quick access to the 7 high-performing, time-tested readymade portfolios with a decade-long market-beating track record. Don’t miss out on exclusive discounts available and Subscribe Now!

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