Some observations on smallcases

The smallcases entice many investors due to ease of investment, delight factor, and continuous monitoring. However, it may not be suitable to many investors if used incorrectly. And in many cases, there is mis-selling too. The following considerations are important while subscribing to any smallcase:

Subscription fee: Currently, most of the smallcases offer subscriptions on a fixed-cost basis that ranges between ₹3000 to ₹18000 annually charged monthly or quarterly. Let us assume that your investment capital is ₹50000, and you have subscribed to a smallcase charging ₹12000 pa. This amounts to a humongous expense ratio of 24%. Typically a mutual fund has an expense ratio of 0.5-1.5%. It also means that the smallcase has to provide a 24% CAGR to break even, which is quite difficult. Therefore, the takeaway is that unless your capital is large, subscribing to smallcases doesn’t make sense. If a typical smallcase charges ₹12000 pa, then a capital of ₹1000000 would result in an expense ratio of 1.2%, which is comparable to mutual funds. So unless your capital is more than 1000000 a smallcase is not suitable for you. More than returns, cost-adjusted return is vital to look at.

Ideally, smallcase managers must reveal this aspect to the naïve investors, but many don’t, which essentially is a case of mis-selling.

Some smallcases, however, charge a subscription fee as a % of the invested capital that hovers typically around 1.5 %. But this genre of smallcase is in the minority.

 

Capital gain taxes: Unlike a mutual fund, smallcases lead to capital gain tax liability on the subscribers as shares are held in the Demat account of investors. So smallcases must provide a higher CAGR relative to mutual funds to justify their raison d'être. The transactions by the mutual fund managers do not cause the incidence of tax liability on the mutual fund unit owners; on the other hand, the rebalancing (monthly or quarterly) in a smallcase makes the subscriber liable to pay capital gain taxes. Assuming that a smallcase componants change 100% in a year, we have to pay 15% tax on the short-term gain accrued from the smallcase. Therefore, a smallcase showing 24% CAGR means a tax-adjusted CAGR of only 20.4% [24*(1-0.15].

The capital gain implication of the smallcase is the most neglected aspect. So before being carried away by the high CAGR of a smallcase, adjust tax incidence.

 

It's not a bias-free option: Biases are one of the biggest enemies of investors. When it comes to smallcases, certain biases are at work too. For instance, most smallcases with high immediate past performance catch the eyes of naïve investors. Most extrapolate the past performance to the future, thinking that history will repeat. However, the list of top-performing smallcases keeps churning just like mutual funds. So if a Chemicals-focused smallcase has outperformed the market during the last 2 years, it does not necessarily mean that it will continue to beat the market in next years. Sector-rotation happens, commodity cycles occur, period of momentum is followed by a period of value. If we are not cautious, we may fall prey to any of the above biases.

The ease of subscribing and exiting from smallcases and continuously seeing the performance in real-time is also too tempting. We need to remain invested for a long term to benefit from a strategy. So impatient investors may jump from one smallcase to another, affecting their performance negatively.  

 

Slippage, brokerage, STT etc: Its not only subscription-fee that dents your portfolio performance but also the slippage caused by the market orders pushed by the smallcase (smallcase don’t allow limit orders), STT, and brokerage charges that eat away our profits. Especially in the case of less-liquid stocks, the slippage may be significant. So a smallcase focused on less-liquid stocks is not cost-effective in general.

Conclusion: Smallcases offer an exciting way to manage our investments. However, it's not a panacea for our investment worries, and we can’t rely on outsourcing the thinking process. The factors mentioned above have to be considered before subscribing to a smallcase.