Numerous fund houses define micro-cap indexes differently. Some fund houses only make investments in companies that are part of the S&P BSE Small Cap index. Others sort businesses per their market capitalization; the top 100 companies are identified as large-cap, the next 100 as mid-cap, and the next 100 as small-cap. Anything below this point is considered a micro-cap company. Notably in 2015, out of 300 diversified equity funds (except for a few such as sectoral, tax-saving, and thematic), nine of the top ten funds by returns focused specifically on companies that were mid to small size. A further six of these were considered “tiny companies”. Commonly, these mutual fund schemes are called micro-cap funds.
Fund houses find the process of differentiating their large cap funds apart from their competitors a challenging prospect. This is due to the launch of exchange-traded funds and the expansion of the equity market. As more and more of these funds move center stage, the ability to beat out peers will only continue to get more difficult. Due to these challenges, fund houses have turned to focusing their attention on smaller companies. They want to be the first to spot a small gem before competitors set their sights on the same target and raise the price of the stock with investments. The primary category that sits in the center of this melee is micro-cap funds.
It would be understandable if one were to confuse small-cap companies with micro-cap companies. After all, the words “small” and “micro” are nearly synonymous with one another. Be mindful that there very well is a difference between the two. The simplest way to differentiate the two is to understand that micro-caps are tinier than small-caps. Due to its small stature, fund managers tend to have a preference for micro-cap funds to be closed-end. Because closed-end funds have the ability to freeze inflows and outflows, long-term calls can be taken by fund managers. Ultimately, the actual number of open-ended micro-cap funds are few overall.
It takes time for a micro-cap company to grow. If they’re well managed and service a sector of the market that has the potential for expansion it’s only a matter of time before it begins to experience some growth. These small companies, however, can fizzle out just as easily due to their small size. As smaller companies grow, it’s recommended to have a lengthy long-term horizon. MF distributors and financial planners alike advise avoiding micro-cap funds with a time horizon of less than seven years.
The biggest problem with micro-cap companies is its liquidity. Many of these businesses are illiquid, meaning that there are few participants and a low volume of activity. Fund managers avoid taking significant risks because it could be difficult to get their money back out of the company if things go wrong. The one silver lining is that there can be a major reward for those who are patient. Micro-caps can generate significant returns if the market conditions are right. Just remember, when it comes to investing in micro-cap companies, with high risk comes high return.
Learn more about Micro-cap Funds; consult us at C.L. King & Associates.
C.L. King & Associates is a full-service investment bank and self-clearing broker-dealer founded in 1972. We provide investment banking, equity research, sales and trading, and investor services to corporations and institutions.
We co-manage bond offerings, IPOs, follow-ons, secondaries, convertibles, and preferred. In addition, we transact directly in the capital markets on behalf of corporations through our Corporate Services business focused on share repurchase and continuous share offerings (“ATMs”).
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