The Indian investment landscape thrives on diversity, and micro-cap mutual funds stand out as a unique and potentially explosive segment.

These funds delve into the realm of India’s smallest publicly traded companies, venturing beyond established giants to unearth hidden gems brimming with growth potential. But like a captivating adventure, this potential comes with a dose of risk, making micro-cap investing a thrilling yet intricate task.

If you are considering adding a touch of micro-cap magic to your portfolio, you are at the right place let’s take an in-depth look into micro-cap mutual funds. Now, let’s define the micro-cap universe.

What Are Micro-cap Mutual Funds?

Micro Cap Mutual Funds are specialised investment funds that primarily invest in micro-cap companies, typically those with a market capitalisation of less than Rs 5,000 crore. The emphasis is on small-scale businesses that have enormous room for expansion.

However, since they are more exposed to small-scale businesses than other funds, they also entail a higher amount of risk. For example, a fund manager of a micro-cap mutual fund might choose to invest in a small tech startup that is developing an innovative product.

[Read: Micro-cap Stocks Rally Drives Mutual Fund’s Interest, But Are They Worth Investing?]

Investors stand to gain a great deal if the startup succeeds as the mutual fund’s shares in the business will appreciate in value. On the other hand, the investment may lose money if the startup fails. Thus, due to this uncertainty, micro-cap mutual funds are considered to be highly risky.Top of Form

Mutual funds must adhere to the market capitalization classification framework established by the Securities and Exchange Board of India (SEBI) in 2017 when making investments. In terms of entire market capitalization, large-caps are defined as the first through 100th corporations, mid-caps as the 101st through 250th companies, and small-caps as the 251st company and beyond. This list is updated twice a year by the industry association, the Association of Mutual Funds in India (AMFI).

Considering that micro-cap firms are ranked lower than 250 in terms of market capitalization under SEBI standards. Simply put, they have a smaller total market value than well-known giants, and businesses that rank lower on the Nifty 500 list in terms of total market capitalization are typically referred to as micro-caps.

Since micro-cap businesses are frequently youthful, nimble, and full of creative ideas, they may have a larger growth potential. The hitch is that this potential is linked to higher volatility. Micro-cap firms are more vulnerable to changes in the industry, developments in the economy, and even mistakes made by management.

Furthermore, the exposure of Indian mutual funds to micro-cap firms has increased faster than the expansion of overall equities assets, despite the pricey valuations, which raises risk concerns. If small-cap investing is too risky for you, then micro-cap betting is an even riskier proposition.

In the midst of a strong rally in the overall market, investors and mutual funds have recently developed a keen interest in the micro-cap segment of the equity market.

Investing in Micro-Cap Mutual Funds: Unveiling the Pros and Cons

• The Allure of High Returns: Historically, micro-cap funds have outperformed their larger counterparts, offering the potential for significant wealth creation. The 2023 surge, with substantial average returns, serves as a recent example. This explosive growth attracts investors seeking to supercharge their portfolios.

Graph: Micro-caps outperform over the long-term

Base taken = Rs 10,000

Index	Absolute Return (%) 1 year	P/E
Nifty 50	23.39	22.51
Nifty 100	27.14	23.13
Nifty Mid-Cap 150	54.32	22.51
Nifty Small-Cap 250	64.75	28.52
Nifty Micro-Cap 250	90.12	32.39

Data as of February 12, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: NSE, ACEMF, data collated by PersonalFN)

Experts say that over the medium to long term, micro-cap stocks have outperformed the Nifty 50 index by a wide margin. In India, the Motilal Oswal Nifty Microcap 250 Index Fund launched in June 2023 and has delivered a 52.04% return since inception (as of Feb 12, 2024).

However, it’s important to acknowledge that the micro-cap segment seems to be getting ahead of itself regarding valuations. In light of this, investors should navigate this space prudently, as there are quite a few stocks that appear to be trading at prices that are higher than justified.

• The Risk Factor: Micro-cap investments are inherently volatile. Unlike large-cap companies with established track records, these smaller players can experience dramatic swings in valuation. This volatility demands a high tolerance for risk and a long-term investment horizon.
• The Power of Diversification: While individual micro-cap stocks can be risky, micro-cap mutual funds offer a layer of diversification by spreading your investment across several companies. This helps mitigate some risk, but remember, it’s not a complete shield.

Navigating the Micro-Cap Space…

One needs to understand the investment strategy; each micro-cap fund follows a distinct philosophy. Some focus on specific sectors, growth potential, or value investing. Align your choice with your individual risk tolerance and investment goals.

Analyse the fund’s historical performance, considering both ups and downs. Do not solely rely on short-term returns; prioritise funds with consistent performance over extended periods. Again, bear in mind that past performance is not an indicator of future returns; it only assists investors in making informed investment decisions.

Among different options, one may also compare the expense ratio, which covers the fund’s management fees. Opt for funds with lower expense ratios to maximise your returns. Research the fund manager’s experience and track record in managing micro-cap investments. Their expertise and understanding of the unique dynamics of this market are crucial.

Generally, small-cap funds are compared to micro-cap funds; however, here are some differentiating elements:

The primary difference between micro-cap and small-cap mutual funds lies in the size of the companies they invest in. Mirco-cap mutual funds invest in the smallest companies with high growth potential. Whereas small-cap funds invest in larger than micro-cap but smaller than mid and large-cap companies.

Small-cap funds are prone to moderate volatility due to the size and nature of companies, while micro-cap funds could be highly volatility due to the smaller size of companies from the untapped markets. The investment strategy for both these funds differs, as micro-cap funds focus on identifying undervalued micro-cap companies. In contrast, small-cap funds focus on small-cap companies with growth potential.

[Read: Reasons That Should Not Be the Basis for Investing in Small-Cap Funds]

Regarding risk, both segments are considered to be highly risky and sensitive to price fluctuations. Mirco-cap funds carry higher risk due to the smaller size of companies, whereas small-cap funds comparatively carry lower risk than micro-cap funds.

Are Micro-Cap Funds Right for You?

Before venturing into micro-cap territory, take a brutally honest assessment of your risk tolerance, investment horizon and goals. These funds are suitable for aggressive investors with a long-term perspective and the ability to stomach significant fluctuations. Consider your age, income, investment goals, and overall portfolio diversification before taking the plunge.

A few points to be noted:

• Begin with a small allocation in your portfolio and gradually increase your exposure as you gain comfort;
• Build a diversified portfolio and spread your micro-cap investments across different funds and asset classes;
• Keep yourself updated on economic trends, industry developments, and company news impacting the micro-cap space;
• Don’t panic during market downturns. Remember, volatility is inherent to micro-cap investing, and a long-term perspective is key;
• However, if you’re unsure, consult a financial advisor who specialises in alternative investments and understands your risk tolerance.

To Summarise…

Micro-cap mutual funds offer an exciting avenue for seeking potentially explosive returns. However, the inherent risk and volatility necessitate careful consideration and thorough research. If you’re willing to embrace the thrills and chills of the micro-cap world, it might just unlock hidden treasures in your investment journey.

Remember, micro-cap investing is at a nascent stage in India, it is yet to build a robust track record and thus the key lies in understanding your risk tolerance, diversifying your portfolio, and approaching this investment with a long-term perspective and a level head.

This article first appeared on PersonalFN here