Small Cap mutual funds turn riskier as they invest more in micro caps: Report

Fund managers of small-cap mutual funds have invested large amount in micro capital stocks over the past one year, while they explored and capitalised on their potential, reported Business Line.

ACEMF data show a considerable jump in micro-cap stock allocations within small-cap fund portfolios, rising to 31 per cent in January 2025 from 25 per cent in January last year. Reportedly, the share of small-cap stocks fell during the same period from 49 to 43 per cent.

Liquidity concerns

Despite the risks linked with micro-cap stocks such as heightened volatility, limited liquidity and increased vulnerability to market downturns, small-cap fund managers seek opportunities in this under-researched segment to effectively deploy their steady and uninterrupted inflows.

Stocks ranked below 250 in terms of market capitalisation are categorised as small-cap, with no formal classification for micro-cap stocks. Stocks ranked below 500 are considered as microcaps for this study.

Small-cap funds are required to allocate a minimum of 65 per cent of their investments to stocks ranked below the 250th position. There are no restrictions preventing these funds from delving further down the market-cap ladder, cap segments, the market capitalisation threshold for the 501st stock has now risen to ₹11,227 crore, as per the latest classification as of December 2024.

This extraordinary growth has opened new opportunities for small-cap fund managers to explore this segment, enabling both diversification and the potential for alpha generation. It has reflected in the total number of micro-cap stocks invested in by small-cap funds that increased significantly from 292 to 387 in the past year.

Meanwhile, it continues to be a high-risk segment due to lower liquidity, higher volatility and potential governance issues. Retail investors should carry out due diligence to avoid pitfalls such as price manipulation or fraudulent practices in the microcap segment.

Notably,  small cap funds have emerged as the best-performing segment among all mutual fund categories, with 86.21 percent of schemes outperforming their respective benchmarks, revealed PL Wealth Management study.   

These funds benefited from renewed investor interest in high-growth small-cap stocks, despite broader market volatility.