The lure of small caps is the equivalent of a pandemic in the investment world. They transmit virally in a bull market until everybody only wants to own them. Then, the markets collapse leaving investors with huge losses. Worse still, the stocks will be very illiquid. This makes the small cap segment the most difficult segment to invest into for both institutional and retail investors. Yet, the lure never reduced.

We saw this in 2018. Investors never seemed to have enough. SEBI made a move to shorten the category of small caps and narrow it to between 251st and 500th companies by market capitalisation. Even when the regulation tried it’s best to stop the frenzy and control excesses, the lure was unaffected. Why?

Participants invariably think highest returns accrue from the smallest companies as they enjoy very high growth headroom. When you restrict this universe further to just 250 companies, different sections of the markets tend to invest into the same subset of stocks. This causes momentum build-up, valuations to rise swiftly, volatility to reappear, and at times induce euphoria.

Creating a market capitalisation floor for small caps and leaving it to the wisdom of managers is a simple way to avoid manipulation, crowding, and euphoria. By forcing everybody to buy within the same subset of 250 stocks in a mutual fund category which is 1.5 lakh Crores in size, we are setting ourselves up for a future blame game and crisis of confidence.

Clearly, the onus is on investors to move to safety as fund managers just lost that option. Erring on the side of caution is now a personal responsibility.

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