The joke may again be on retail stock investors in the latest rally

Data published recently by the Association of Mutual Funds in India—the mutual fund lobby—tells us that the number of folios of small cap equity mutual funds (MFs) as of August had shot up to 13.85 million, a jump of a little over 27% from March. To put it another way, more than a fifth of the investment folios of small cap MFs that are currently in existence were created during this financial year.

Now, to give a sense of comparison, the number of folios of equity MFs on the whole rose by only 6.6% to 104.78 million during that period. If one takes a look at large cap MFs, the overall number of folios has barely moved from 12.97 million at the end of March to 13 million at the end of August. Large cap MFs largely invest in large cap stocks—or stocks ranked in the top 100 on the basis of market capitalization.

Even other types of equity MFs haven’t seen the same kind of jump in popularity as small cap MFs recently have. Let’s take the case of midcap MFs: between March and August, the number of folios of these funds went up 9.5% to 11.63 million. Midcap MFs largely invest in midcap stocks—stocks from rankings 101 to 250 in terms of market capitalization.

So, clearly there is a great fascination with investing in small cap stocks right now and many retail investors are doing that indirectly through equity MFs. What explains this popularity? Between March and August, the BSE SmallCap Index has rallied by a huge 37.8%. During that period, the BSE Sensex—which is a large-cap index and India’s most popular stock market tracker—gave a return of around 14.4%, a fantastic figure for a period of five months, but one that pales in comparison with the return given by small cap stocks.

And this explains the fascination of retail investors with investing in small caps, given that nothing gets them more interested in stocks than their recent performance. In fact, just in August, the number of folios of small cap MFs went up by a huge 0.83 million (830,602 to be exact). The explanation for this lies in the fact that the BSE SmallCap Index gave a return of close to 30% between March and July.

Now, there are several lessons that come out of this data. First, more money has come into small cap MFs in August, when the price-to-earnings ratio of the BSE SmallCap Index was at around 29, than in April, when it was at 23.4. This is again a reflection of the fact that retail investors typically come to the investing party only after prices have already rallied quite a bit.

Second, most retail investors do not seem to understand the risk-return paradigm well. While high risk can lead to high returns, there are no guarantees. Small cap stocks are the riskiest of the lot—meaning they can fall as quickly as they rise and then stay there.

Let’s look at data to understand this. The BSE SmallCap Index had stood at 7,004 points as on 2 January 2007. It doubled to 13,975 points by 7 January 2008 and then fell by almost four-fifths to 2,867 points by 9 March 2009. Also, the high of 13,975 points reached in January 2008 was crossed again only on 16 March 2017, more than nine years later. So, clearly the risk of investing in small cap stocks, even for a long duration, is huge. In the frenzy of the moment, this isn’t something that most retail investors seem to understand.

Third, some TV channels are driving a narrative of a battle between small retail investors and large foreign investors and how it’s the small investor who is winning this time around and how that doesn’t seem to be going down well with the large investors. While this might make for good TV ratings, it doesn’t really tell us anything. Past data clearly shows us that large foreign investors generally tend to buy Indian stocks when their valuations seem reasonable, with retail investors coming in only once valuations are really stretched.

Foreign institutional investors (FIIs) have invested a total of $19.7 billion in Indian stocks from April to August. But a bulk of these investments happened between May and July, when valuations were much more reasonable than they currently are. In September, FIIs have net sold stocks worth $537 million. So, the joke—as and when they get it—will again be on retail investors.

Finally, on 11 September, Kotak Institutional Equities came out with a damning report on small-cap and mid-cap stocks. The brokerage said that there had been no meaningful change in the fundamentals of most such companies. “In fact, they have worsened in many cases," it added. Irrational exuberance among investors seems to be driving the current rally.

Now, stock brokerages rarely put out such reports simply because it would harm their interests, as they make more money when investors keep buying stocks. No stock broker makes money by telling investors to stay away from investing in a certain category of stocks. But even with this incentive, if Kotak is saying what it is, maybe that’s something worth thinking about.