All about DSP Merrill Lynch Micro Cap Fund

The primary investment objective is to seek to generate long term capital appreciation from a portfolio that is substantially constituted of equity and equity-related securities, which are not part of the top 300 companies by market capitalisation. From time to time, the Investment Manager will also seek participation in other equity and equity-related securities to achieve optimal portfolio construction. This shall be the fundamental attribute of the Scheme.
*Source: Offer document

DSP Merrill Lynch Mutual Fund is among the first few fund houses to launch a small cap fund (or a micro cap fund, as the fund house likes to put it) - the DSP Merrill Lynch Micro Cap Fund (DSPMCF), a close-ended fund that will turn open-ended after 3 years. The first fund to be launched in this segment was the Franklin India Smaller Companies (5-Yr close-ended fund launched in December 2005); Sundaram Select Small Cap Fund (5-Yr close-ended fund launched in January 2007) is another small cap fund.

DSPMCF is a little different as compared to the other small cap funds launched so far, in at least two aspects. One, it's a lot more 'micro'; this means that the fund will select companies that are really small in terms of market cap (market capitalisation). It has indicated that it will scout for companies with a market cap of less than or equal to Rs 15 bn (Rs 1,500 crores). By its own calculations the top 300 companies by market cap, will be excluded from the fund's investment universe. Many of the existing small cap funds can invest in any company outside the top 100 companies by market cap; such funds therefore generally have even the mid-sized companies (or mid caps, as they are known) in their portfolios.

The second aspect in which DSPMCF stands out is the ceiling on net assets. It has announced that it will not accept more than Rs 5 bn (Rs 500 crores) in the fund, given the liquidity constraints (which can translate into considerably higher risk) in the small cap segment.

To be sure, by being different and including really small companies in its investment universe, DSPMCF's risk profile is enhanced manifold. Small caps are under-researched; there is relatively inadequate information on them (when compared to large and mid caps), so the chances of a fund manager making an ill-advised investment is relatively higher. Also in terms of systems and processes, small caps are usually in an evolutionary stage, so if not identified correctly, there is a possibility that they may throw some unpleasant surprises for the investor. Moreover, as mentioned earlier, liquidity constraints in a small cap can prove perilous, especially during a stock market volatility or a sustained downturn.

However, DSPMCF has tried to lower the risk of investing in small caps by limiting the monies it will accept in the fund. During the NFO (new fund offer), it will accept only upto Rs 5 bn. This will ensure that the fund remains nimble and will not have a problem investing in or exiting from a small cap; in other words risks associated with liquidity in small caps can be mitigated to a certain extent by the fund.

More specifically on DSP ML Mutual Fund - in our view, it is one of the most well-managed fund houses with high focus on investment processes and relatively lower dependence on individual/star fund managers. Across categories, it has some of the better-managed funds with established track records over the long term viz. DSP ML Equity Fund (value style), DSP ML Opportunities (growth style) and DSP ML Balanced (balanced) to cite a few names.

Having said that, managing a full-fledged small cap fund is surely a first even for the fund house. As yet, it only has controlled allocations to small caps in its existing funds (DSP ML Equity, DSP ML Opportunities, DSP ML T.I.G.E.R., DSP ML Small and Mid Cap Fund). Its 'largest' small cap allocation is in DSP ML Small and Mid Cap Fund that was launched a little over 6 months ago.

In our view, DSPMCF presents an interesting investment proposition for the risk-taking investor. The fund house's investment processes are geared to help the fund achieve its investment objective; this is something that we have already seen with many of their funds. Lack of a track record in managing a full-fledged small cap fund (as also a mid cap fund) would normally have inclined us to recommend a wait-and-watch stand on the fund.

However, a ceiling on the monies during the NFO (based on the fund house's discretion, this ceiling may or may not be revised in future) leads us to believe that for a high-risk taking investor, the opportunity to invest in a small cap fund from a well-managed AMC like DSP ML Mutual Fund may not arise again. To that end, we recommend that investors with a very high risk appetite can invest a moderate portion of their portfolio that is earmarked for high risk investments, in the fund (for that, how much they can afford to lock-in for at least a 3-Yr period also needs to be considered). Your Personalfn consultant can help you with the same.

Another caveat for the high-risk taking, albeit impatient investor - small caps take longer to 'mature' (vis-à-vis large caps and even mid caps) and show results in terms of fundamentals (sales, net profit, to name a few parameters). Expectedly, stock prices also take time to reflect the growth in performance. We recommend that investors in this fund, as also investors in Franklin Smaller Companies and Sundaram Select Small Cap exercise patience while evaluating the results of their respective investments. For that, they must be prepared for the long haul; at least 5 years in our view.

Being a small cap fund, expect DSPMCF to work like a typical high risk-high return investment; in other words, depending on how stock markets move over the short-term, there are likely to be sharp surges/dips in the fund's performance. However, over the long-term (5 years), the volatility is likely to be muted and the fund, should it adhere to DSP ML Mutual Fund's well-defined processes, will likely benefit from the performance of a well-selected small cap portfolio.