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Should you invest in close-ended funds which take bets on smaller companies?

Should you invest in close-ended funds which take bets on smaller companies?

The bruising fall in shares of mid- and small-size companies means they are now available at low valuations. Mutual fund managers say this is an excellent opportunity for investors to lock-in money in good small- and mid-cap stocks.

In the six months to July 3, the Bombay Stock Exchange Small-cap Index fell over 25% and the mid-cap index 18% compared to just 3% fall in large-cap indices such as the Sensex and the Nifty.

The reasons for the fall in the market were India's growing trade deficit, falling rupee and fears over slowing of US' liquidity injection programme. So, investors did what they do in such situations - invest in large companies that can sail through bad times without too many bruises. The result was a selloff in stocks of smaller companies.

However, the sharp decline means many small- and mid-cap stocks are now available at low valuations. Mutual fund managers, too, say this is an excellent opportunity for investors to lock-in money in good small- and mid-cap stocks. That is why many of them are launching close-ended equity funds that invest in stocks of smaller companies. However, since investments in these companies require time to mature and give decent returns, these funds have a lock-in period during which investors cannot withdraw the money.

IDFC Mutual Fund has launched IDFC Equity Opportunities Series 1. Two more funds in the series (Series 2&3) are awaiting the approval of the Securities and Exchange Board of India, the equity market regulator. ICICI Prudential Value Fund Series 1 and 2, L&T Emerging Business Fund and Axis Small Cap Fund are some other such close-ended smalland mid-cap equity funds.

Most of these funds have a lockin of either three or five years. However, investors can sell the units on stock exchanges where these funds are listed.

Units of a close-ended fund are sold for a limited period and cannot be redeemed with the fund house before the lock-in ends.

WHY CLOSE-ENDED FUNDS?

"Small- and mid-cap funds tend to move sharply. It has been seen that when they make sharp upward moves, investors are quick to redeem and book profit. This hurts investors who stay on. Plus, it limits fund managers' ability to take long-term bets on good stocks as they have to keep selling a part of holdings to meet redemption requests," says Himanshu Pandya, senior vice president and head, product and communication, ICICI Prudential Mutual Fund.

A close-ended fund does not have these problems. A lock-in gives the fund manager scope to hold a beaten-down stock for a longer period to earn the best returns. This protects the interests of long-term investors as well.


The close-ended nature of these funds solves another problem. Small-cap stocks are often illiquid, that is, selling them is not easy. The lock-in period takes care of this by minimising unexpected redemptions. This is a big problem for fund managers of open-ended funds, where investors can take out money any time they want. So, in case an open-ended fund gets a large redemption request, the fund manager may have to sell illiquid stocks even at a loss.

In contrast, fund managers of close-ended funds hold stocks for longer periods and churn portfolios less frequently. This is evident from the portfolio turnover ratio of existing close-ended equity funds, which are mostly tax-saving funds. A low turnover ratio means a lower expense ratio, as every time a fund manager makes a transaction he pays brokerage fee and securities transaction tax. A turnover ratio of 20% means the portfolio is changed completely in five years. A ratio of 100% means the portfolio is changed totally once a year. Expense ratio is an annual fee charged by the fund manager from investors.

LOW VALUATIONS, REALLY?

Since the start of June, the BSE Small Cap index has been trading over 30 times trailing 12-month earnings. The average price-toearnings (P/E) ratio since January has been 24, too high for small-cap stocks. Even the price-to-book value, or PBV, ratio is more than one (1.18 times). The PBV ratio compares a stock's price to its value in the company's books. It gives an idea about whether investors are paying too much for what would be left if the company went bankrupt immediately.

With ratios as high as these, are small-cap stocks cheap? "A sharp fall in mid- and small-cap indices does not mean that all stocks are available at low valuations. Valuations are stock-specific and investors have to be very selective while picking stocks," says Dipen Shah, head, Private Client Group Research, Kotak Securities.


Despite the high P/E ratio of the BSE Small Cap index, small-cap stocks such as Development Credit Bank, Suven Life Science, Ashoka Buildcon and VA Tech Wabag are available at low valuations. However, some experts advise caution. "The Indian stock markets may still fall 8-10% from these levels. If that happens, even large-cap stocks will take a beating. This will make them more attractive than mid- and small-caps," says Aviral Gupta, founder and fund manager, Mynte Advisors. Gupta has worked with both foreign and domestic institutional investors.

"It is true that small- and midcap stocks have taken a beating recently and are available much cheaper than they were six months ago, but we do not know if their downward journey will stop here," says P V Subramanyam, a financial market expert and chartered accountant.

THE LIMITATIONS

As close-ended funds can be subscribed only during a limited period, one can invest only a lump sum and not through a systematic investment plan (SIP). Investing in small- and mid-cap funds is anyway risky and not having the SIP option increases the risk. Lump-sum investing means investors have to get the timing of the investment right, and past experience shows it is very difficult, if not impossible.

"Investing in small-cap funds through close-ended schemes is not recommended as timing the market is difficult. If you enter the fund at the wrong time you will end up losing most of the capital since the risk of investing in small-cap stocks is much greater," says Anil Rego, CEO and founder, Right Horizons.

Another problem is the lock-in period. This means that even if the fund is not doing well, the investor does not have the option to exit.

Though close-ended funds are listed on exchanges, the trading volume is low, making it difficult for investors to exit through this route. Besides, the price of funds in the secondary market is affected by secondary market volatility. If the units are trading at a discount to the net asset value, it will hurt the investor when he sells in the secondary market.

In spite of the risks associated with small- and mid-cap funds and weak market sentiment, one such fund, IDFC Equity Opportunities Series 1, has got a huge response from investors. The fund garnered Rs 240 crore during its subscription period. IDFC Mutual Fund spokesperson said that the average investment size in the fund was Rs 25,000 with some investors putting in as much as Rs 1 crore.

Investing in small- and mid-cap funds requires investors to be patient. A close-ended fund ensures they remain invested till the lock-in period is over. However, non-availability of the SIP option means timing of the investment has to be correct for the investor to make decent gains.