In 2015, of about 300 diversified equity funds (except tax-saving, thematic and sectoral), nine of the top 10 funds by returns were focused on mid- and small-sized companies. And six of these focused on—in terms of the size of the underlying holdings—tiny companies. These mutual fund (MF) schemes are commonly known as micro-cap funds.

NEED TO DIFFERENTIATE

As the equity market expands and more index funds and exchange-traded funds are launched, it's getting tougher for fund houses to set their large-cap funds apart from their competitors'. Beating the benchmark and peers will also get more difficult as more of these funds make their debut. That's one reason why some fund houses have been launching schemes that tap the smaller range of companies; they try to be among the first to spot such companies before others pick them up as well and stock prices start to rise. One such emerging category is micro-cap funds.

WHAT IS ITS SIZE?

Different fund houses have different definitions of what constitutes a micro-cap index. Some invest in companies that are a part of the S&P BSE SmallCap index. There are other methods, too. For instance, DSP BlackRock Investment Managers Pvt. Ltd sorts the companies as per their market capitalisation.

The top 100 companies are classified as large-cap, next 100 as mid-cap, and the next 100 as small-cap. And anything below that (301st stock and below) is classified as a micro-cap company.

CLOSED-END NATURE

In the pecking order, micro-cap companies are said to be smaller than even the so-called small-sized companies. Due to the small size of these companies, fund managers prefer micro-cap funds to be closed-end. In 2014 and 2015, many such funds, especially from two fund houses, were launched and all of them were closed-end, and thus in a series. Since closed-end funds freeze inflows and outflows, fund managers can take long-term calls. There are only a few open-ended micro-cap funds.

HIGH-RISK, HIGH-RETURN

As micro-cap companies take time to grow (provided, of course, they are well-managed), it's best to have a very long-term horizon. Some financial planners and MF distributors do not recommend micro-cap funds to anyone whose time horizon is less than seven years.

One big risk in these companies is liquidity. Most small-sized companies are illiquid, and fund managers avoid taking concentrated exposures as it could get challenging to sell these stocks if there is panic redemption. But for those who are patient, these can be rewarding. As against an average of 1.74% return given by diversified equity funds this year, micro-caps returned 10-16%. So, before you decide to invest in a micro-cap fund, remember the risk–reward equation.

1. BNP Paribas Long Term Equity Fund

2. Axis Tax Saver Fund

3. Franklin India TaxShield

4. ICICI Prudential Long Term Equity Fund

5. IDFC Tax Advantage (ELSS) Fund

6. Birla Sun Life Tax Relief 96

7. DSP BlackRock Tax Saver Fund

8. Reliance Tax Saver (ELSS) Fund

9. Religare Tax Plan