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Micro-cap companies are riskier than large-cap companies that have a large market capitalization. These funds have a very high-risk factor attached to them. They have an unproven track of performance history, assets, etc. The lack of liquidity of these very small sized companies along with their small base of shareholders further leaves them vulnerable to market shocks. Having said that, as an investor, if you are willing to take these high risks, the returns from these funds can be very high when compared to the total size of the fund itself.
Following the directives of the Securities and Exchange Board of India (SEBI), there has been a reclassification of funds for the ease of investment. With the expansion of the equity markets and more exchange-traded-funds and index funds, it was becoming increasingly difficult for Asset Management Companies to differentiate between large cap and other funds, and hence it culminated into offering schemes that catered to small-cap firms. Fund houses, therefore, launched schemes that tapped into smaller companies before others picked them or their prices started to rise. Such an emerging category of funds is referred to as micro-cap funds.
The definition of micro-cap funds differs in different fund houses. Some of the fund houses invest based on the market capitalization, while others do so based on the S&P BSE SmallCap Index. The top 100 companies in the list are categorized as large-cap, while the immediate next 100 are mid-cap, followed by the next 100 referred to as small cap. The remaining companies, ranking 301 and beyond, are classified as micro-cap companies.
Given the size of micro-cap companies, if managed well, they have the potential to grow, but that takes time. As an investor, it is better if you have a long-term investment horizon. This means you should be willing to invest for longer than seven years. One major risk factor is the company's liquidity. Most of these companies are illiquid and fund manager have to avoid concentrated exposure. With such high risk, the returns are of an equally high nature. When investing in these funds, it is important to be mindful of your own risk tolerance.
As the micro-cap companies are smaller than even small-cap companies, fund managers prefer close ended micro-cap funds. In fact, barring for one or two exceptions, all micro-cap funds are close-ended. This helps to restrict the cash influx and outflows, which further enables asset managers to take long-standing decisions. Another reason why this fund is closed-ended is also that of the illiquid nature of these funds. Higher exposure to these funds would leave them vulnerable to sudden market volatility which could then lead to panic redemption by investors.
Investors should keep some basic points in mind before investing in micro-cap funds. Know your objective for investing. Understand the liquidity factor or the lack thereof, before opting for micro-cap funds. The prospects of high returns can’t be the only determinant in the choice of this fund. Like any other fund, these relatively new and lesser known funds would also go through the various market cycles and returns may not be as lucrative then. It important for you to pick funds that you can stick to for a long time. Having an experienced manager with prior experience in identifying such companies is of prime importance.
Investing in micro-cap funds, like any mutual fund, is subject to market risks, but the risk with micro-cap companies is more so due to the size of the company. To learn more about the advantages and disadvantages of investing in mutual funds, visit https://cleartax.in/s/mutual-funds.
If you are not sure whether this investment class suits your needs and risk appetite, visit ClearTax for more details on MicroCap Funds and other investment options. We have the best of mutual funds on offer, hand picked by financial experts.