The best way to invest in smallcaps (without fear)
WTF #13 Smallcaps are extremely attractive because of the high return potential, but scary at the same time. Not anymore!
In the Interim Budget 2024, FM Nirmala Sitharaman urged investors and industries to invest in the new-age sectors as these sectors provide immense opportunities.
And why not? The Indian economy has showcased resilience in the face of global uncertainties.
Even with the world economy showing signs of deceleration with global leaders like UK and Japan falling into recession at the end of 2023, India remained the fastest growing economy in the world!
Moreover, the Government of India is working on making India a developed nation or “Viksit Bharat” by 2047 and emerging sectors will play a huge role in that.
Government recognises the high growth potential of the sunrise industry, and has taken a series of initiatives to
— enhance our domestic production capabilities (atmanirbharta) and help India become the global leader (vishwa guru).
This has made India an attractive investment destination.
And we, as retail investors, can benefit from it too.
Why investing in India’s growth story is a smart bet(a) for you
Now, what is it that you, as an investor, want from your investment?
High growth, definitely! Who doesn’t like being Richie Rich!
And smallcaps have a high growth potential, giving you an opportunity in undervalued parts of the market where, if you get in early, you can grow with the company.
Because smallcaps of today are largecaps of tomorrow.
But you also want low risk and transparency, so that you don't have to face unpleasant surprises in future.
And smallcaps are extremely high-risk.
Choosing smallcap stocks can be really tricky unless you have an in-depth understanding of the company.
Picking individual smallcap stocks might also result in over-concentration in individual bets that might not work.
And a lot of times, smallcap companies even fudge their numbers to trick investors.
So, it becomes very difficult as a retail investor to play safe and choose the right smallcaps for yourself.
Now, let’s say you’ve decided to choose a mutual fund instead of individual smallcap stocks for this reason.
But then, you get stuck between trying to invest in index funds which are passively-managed and have so many companies, that your returns get diluted.
Or you become insecure about what’s going on with your money in an actively managed mutual fund.
Simply put — Smallcaps as a category has outperformed largecaps, but because of lack of knowledge & high risk, people lose money in them.
Even though S&P BSE Smallcap index has given 4996% returns since 2003, while Nifty50 gave just 1948%.
But what if we told you that the best of both worlds — active and passive investing — is actually possible?
This is the reason why Smart Beta funds are gaining popularity all across the globe.
Before we get to smart beta funds, if you want to dive deeper into the art of investing in smallcaps and learn the right way from experts, listen to our recent X/Twitter space here: https://twitter.com/i/spaces/1PlKQDznQzYxE
Harnessing the power of factor investing
Now, coming back to Smart Beta funds.
These are a hybrid of passive and active funds — and they have factors or rules to select stocks from a particular index.
Which means, you get:
👉 the transparency of a passive fund, as well as
👉 the filtration of an active fund.
Now, what are the factors?
Factors are any desirable traits relating to a stock or portfolio that are important in explaining its returns and risks.
There are mainly 2 types of factors:
👉 MACROECONOMIC FACTORS that influence the overall performance of an economy, and
👉 STYLE FACTORS that refer to specific attributes used to categorise and analyse different types of stocks.
The aim of factors is to enable generation of potentially excess returns over the market.
And factor investing is basically a strategy to identify and invest based on these definable traits (factors)
— to target a desired performance profile, reduce volatility, and enhance diversification.
The aim of factor investing is to provide the benefits of diversification, which minimises a portfolio’s exposure to risk.
And factors can help improve diversification because style and macroeconomic factors cover various situations in the economic cycle.
They can be used in isolation or combination to create a unique basket of stocks.
Now, Smart Beta is one subset of factor investing.
For example, let’s understand them even better by understanding Mirae Asset’s Nifty Smallcap 250 Momentum Quality 100 ETF Fund of Fund.
Mirae Asset Nifty Smallcap 250 Momentum Quality 100 ETF FoF
It’s a smart beta fund based on the Nifty Smallcap 250 Momentum Quality 100 (SMQ) index, whose parent index is the Nifty Smallcap 250.
In the SMQ index, stocks are filtered/excluded on the basis of following criteria to address the liquidity issues:
Listing Criteria: If minimum listing history is less than 1 year
Circuit Filter Breaker: Non F&O stocks hitting upper or lower circuit on 25 days or more in 6 months
Pledged Promoter Share: Percentage of pledged promotor’s share greater than 20%
Low Average Daily Trading Value (ADTV): Bottom 10 percentile stocks on ADTV basis in last 6 months
Low Turnover Ratio: Bottom 10 percentile based on stock’s daily trading value relative to its free float market cap
But wait a minute. Why choose to follow the SMQ index over its parent index?
Why carry out the filtration and design the fund based on quality and momentum factors?
See, since 2005, the index has outperformed both its parent index, as well as the Nifty50 Index (numbers present in the table).
But how has it been able to generate such high returns along with low volatility?
Because of its stock selection criteria which focuses on the quality and momentum factors.
The combination of quality and momentum factors works like a see-saw. It creates a balance.
Momentum captures stocks with upward price trends, which perform well in bull markets but may have higher drawdowns in turbulent markets.
It is categorised as a “persistence” factor, i.e., it tends to benefit from continued trends in markets.
On the other hand, Quality captures stocks that are characterised by low debt, stable earnings growth, and other “quality” metrics which indicate a company’s financial health.
Basically, quality is evaluated based of three factors:
Profitability — Return on Equity (ROE)
Financial Health — Debt to Equity Ratio (D/E)
Earning Quality — Earning Per Share (EPS) variability
These stocks are stable and robust — especially during bear markets.
So, all in all, if you’re scared to invest in smallcaps directly, but you still want to take advantage of India's growth driven by smallcaps, smallcap funds can be a great alternative.
Master the markets with Mirae Asset’s Nifty Smallcap 250 Momentum Quality 100 ETF FoF.
Disclaimer: Please do your own research before investing.
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Great post with a tonne of useful information regarding smart beta funds.