Can you imagine a company where the owner refuses to accept new clients/business? It sounds unusual, doesn’t it? Typically, a business owner might refuse new clients if they lack the bandwidth, believe they cannot meet the clients’ expectations, or aim to ensure the best outcomes for existing clients. This is precisely what is happening in the Indian Mutual Fund (MF) space, with many small-cap mutual funds stopping lump-sum investments.
The Unusual Confidence of Investors
Consider this: fund houses are stating they cannot provide a good investing experience due to current market conditions, thus discontinuing inflows. However, investors are insistent, seeking to invest lump sum amounts regardless. Isn’t it strange that investors have more confidence than the fund managers themselves? This overconfidence is unusual and potentially risky.
When investors keep investing lump sums, it forces the fund manager to invest in already overvalued stocks. Fund managers might try to mitigate this by allocating more to liquid large caps and cash, but their options remain limited. This can lead to a situation where the returns do not justify the investments, especially if market corrections occur.
Three key factors affect future returns: Top line Growth, Margin Expansion, and Valuation Expansion. Currently, Top line Growth is moderating to low single digits compared to last year. We are sitting on all-time high margins and all-time high valuations. On a trailing basis, valuation is at more than the 90th percentile of its valuation history. The BSE Small cap index, trades at 36x trailing earnings and 3.76 times price to book. This leaves little margin of safety. Investors are advised to exercise caution in allocating large sums of equity investments to overpriced parts of the market. This has high likelihood of poor investor experience over the next 2-3 years.
The SEBI Stress Test Saga
Adding to this caution is the involvement of the regulator, SEBI, which has implemented stress tests for mutual funds. These tests aim to ensure that funds can withstand market shocks and protect investor interests. This regulatory involvement underscores the seriousness of the situation and the need for investors to be vigilant. Investors should heed these signals and adjust their strategies accordingly to ensure long-term gains and minimize risks.
What Should Investors Consider?
Given these conditions, small-cap fund investors might want to consider the following strategies:
- Fresh Lump-sum Investments: Exercise caution due to current market valuations.
- SIP (Systematic Investment Plan): Continuing with existing SIPs could help mitigate risk through periodic investments.
- Old Investments: Review your existing investments with a financial advisor to determine if it’s an opportune time to lock in profits from recent high returns.
The small-cap segment has delivered impressive returns over the past three years, upwards of 25% CAGR. However, it’s rare to have both excellent past performance and strong future performance in such a volatile segment. Hence, prudence suggests enjoying the profits now and waiting for a more opportune time to re-enter the market.
Nippon, Tata, ICICI Prudential, and SBI have stopped accepting Lump Sums in Small caps. Kotak, Axis, and Franklin have announced restrictions on lump sum inflows in their small-cap funds. They represent ~50% of the total small-cap MF universe by AUM.
About Fortune Wealth and Financial Services LLP
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CFA Munjal Mehta
Business Head,
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