Decoding micro-cap funds — factors to consider before investing

Since Motilal Oswal's micro-cap fund is the first one, there is no track record to rely on.

"However, generally it has been observed that there are periods when micro caps tend to perform well. They tend to be more volatile and thus correct sharply when markets correct," Alekh Yadav, Head of Investment Products at Sanctum Wealth, a wealth management firm, said.

According to Jhanwar, micro caps come with their own set of challenges of liquidity, long period of underperformance, information asymmetry, lack of robust corporate structure and assessment of transparent practices.

"If we talk about stocks too, there are very few that are able to achieve this feat and the mortality rate or lack of stock price realignment takes a much longer time. The sheer market cap size and available liquidity make it difficult for lot of money to chase this sector.  Identifying a potential micro cap requires specialised skill sets and if proven right, they can prove to be multibaggers as the journey of stocks essentially is from a micro cap to small cap, mid cap and moving all the way to large cap," he told CNBC-TV18.com.

While experts believe that more AMCs might be planning micro-cap funds, one must be cognisant that too much funds will face the issue of deployment and underperformance as this sector is marred with relatively lesser liquidity compared to small caps, Jhanwar said.

Liquidity ratio represents the number of days it will take for the fund manager to wind down the entire portfolio without negatively impacting prices. The liquidity ratio for small cap funds is normally 25 days.

As Indian investors become more mature in their approach, their allocation towards risky asset classes is increasing and micro-cap funds' allocation has the potential to generate alpha returns over a long-term period.

Given the smaller size some of micro-cap companies, Yadav believes that these may have high potential for growth if the business model of the firm is strong.

"However, these companies are under-researched and may have corporate governance issues. Hence, investors may end up making good returns but the risk is also much higher. Currently, there is one dedicated micro-cap fund by Motilal. However, it is important to note that many mid- and small-cap funds tend to take some exposure to micro caps in their portfolio. Further there are many PMS managers which take significant exposure to micro-cap companies," he told CNBC-TV18.com.

Jhanwar believes that these funds may mostly be ideal for investor's with very high risk appetite. Also, it is better to be invested through professionals who understand this space better. Mostly portfolio management services (PMS) and AIF (alternative investment fund) have a dedicated strategy to focus on this theme.