If investing in small caps is not for the faint-hearted, then betting on micro caps is a much riskier ball game. Now, Motilal Oswal AMC is introducing investors to this uncharted territory with its newest offering—Motilal Oswal Micro Cap 250 index fund. The micro-cap index comprises a basket of 250 stocks beyond the top 500 by market capitalization. This covers businesses with market caps ranging from Rs.1,000 crore to Rs.10,000 crore. It is a pocket that remains mostly unexplored by mutual funds and analysts. Only 4% of the mutual fund assets are invested beyond the top 500 companies (compared to 55% in large caps, 23% in mid caps and 15% in small caps). On average, only two analysts track a micro-cap company (27 for large caps, 16 for mid caps and 7 for small caps).

In fact, 43% of the micro-cap index constituents remain outside the purview of analyst coverage. This leaves potential for significant mispricing of stocks in this space, offering outsized rewards for those brave enough to explore. Says Pratik Oswal, Head of Passive Funds, Motilal Oswal AMC: “We believe that the segment holds immense potential and unique investment opportunities that have been overlooked by many in the industry.” Back-tested data suggests that the micro-cap index has delivered far superior outcomes compared to the small-cap index. Over three-year time frames since April 2005, the micro-cap index has averaged 13.9% annualized returns compared to 12.1% by the small-cap index. Over five-year horizons, the two indices have averaged 13.4% and 11.6%, respectively. However, the micro-cap index is far more volatile than its small-cap sibling.

Over three years, the biggest loss incurred by the small-cap index is -17%, compared to -24% by the micro-cap index. On the flip side, the biggest gain clocked by the smallcap index over a three-year time span is 45%, which pales in comparison to the 63% gain posted by the micro-cap index. Over five years, the micro-cap index has exhibited losses on 15.6% of occasions, relative to the small-cap index’s 8.7%. At the same time, the micro-cap index has delivered in excess of 20% returns in 23.3% of observations, compared to the latter’s 17.3%. So, investors betting on the micro-cap index can intermittently expect bigger (and longer) drawdowns apart from outsized gains. This data does not reflect real-time performance as it ignores the liquidity in the underlying constituents, which will be the key variable for a micro-cap fund, particularly in the passive avatar. Illiquidity is an even bigger handicap in micro caps than in small caps.

LIMITED MARKET PARTICIPATION AND ANALYST COVERAGE LEAD TO MISPRICING

This could offer outsized rewards for those investing in micro caps.

Along with a low market cap, such businesses also have a considerably lower public float—the amount of share capital available for trading. While the average market cap of companies in this basket is `3,161 crore, the average free float is merely `1,253 crore. Often, even this is manipulated by company promoters. The average daily trading volume for stocks in this index is a paltry `5.62 crore, which can be a big constraint for an index fund. An index fund portfolio must replicate its index exactly. So, the micro-cap index must ensure all its 250 constituents are in alignment with the index at all times. Beyond a certain asset size, this daily buying and selling activity in the micro-cap space can be challenging. A Motilal Oswal AMC study indicates that it takes close to three days to trade a quantity of Rs.100 crore in this basket.

MICRO-CAP SEGMENT OFFERS OUTSIZED GAINS, BUT BIGGER DRAWDOWNS

It is far more volatile than even the small-cap segment.

In weak market conditions, it will take much longer. Abhishek Gupta, Founder and Chief Financial Planner, Moat Wealth, warns, “Liquidity will be a huge challenge for this strategy when the market is weak and the fund size gets bigger. It is trickier since hardly anyone operates in the micro-cap space.” Further, given the high mortality rate of micro-cap businesses, the index itself witnesses a high degree of churn. A large proportion of the index constituents keep moving in and out. The index fund will also be forced to replicate this churn, which will inevitably introduce large impact costs. If not managed properly, the fund could experience a significant tracking error— deviation in fund return from its index. On its part, the AMC has indicated that it will stop accepting lump-sum investments if liquidity conditions deteriorate.

This will be crucial for investor return experience. Experts insist that there is no compelling argument to explore this space. Gupta suggests that aggressive investors can instead opt for small-cap strategies with a proven track record. Besides, this market segment is more suitable for active management rather than passive exposure. Feroze Azeez, Deputy CEO, Anand Rathi Wealth, reckons that micro-cap strategies cannot be executed well at the index level. Risk management is critical in this space, which can be handled by a fund manager. While there are no dedicated active funds plying in this arena, several existing small-cap funds offer some exposure to micro-caps.