NFO Insight: WOC Diversified Equity Small Cap Active FoF NFO opens for subscription. How is it different from a smallcap fund?

WhiteOak Capital Mutual Fund has launched its first FoF - WhiteOak Capital Diversified Equity Small Cap FOF, which is open for subscription and will close on October 12. It is an open-ended scheme fund of funds scheme designed to generate long-term capital appreciation by investing predominantly in a diversified selection of active small-cap mutual fund schemes.

According to the product document, rather than selecting individual stocks, the scheme will select, combine and continuously monitor specialist fund managers and their portfolios.

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The strategic allocation of the fund will be to allocate upto 100% in small cap equity managers, a diversified set of small-cap funds chosen for differing styles, factors, and downside behaviour, multi-manager construction tempers the high single-fund volatility of the segment, it will blend funds with experienced, cycle-tested, and drawdown-resilient managers and will built for aggressive growth; suits a longer time horizon and high-risk appetite.

The fund house believes that successful investing is not only about returns, but also about creating an innovative investment journey where an investor can stay committed across market cycles.

What experts say about this fund being different from small cap funds

Experts typically ask investors to avoid investing in NFOs unless they offer something unique. The uniqueness could be that the scheme is offering an investment option that is not available in the market or offering something extra to an existing option. Otherwise, the experts believe investors are better off with an existing scheme with a long performance record. This is because you have some historical data to base your investment decision. You don’t have any data when it comes to new offerings.

Shivam Pathak, CFP and Founder of Asset Elixir told ETMutualFunds a direct small-cap fund depends on one fund manager and one investment approach whereas this FoF takes a multi-manager approach, investing across different small-cap schemes and can change allocations based on factors such as track record, investment style, portfolio overlap, valuations and risk management.

Mukesh Kumawat, Executive Director, Anand Rathi Wealth Limited shared with ETMutualFunds that Major difference from a regular small-cap fund is that the FoF invests in multiple active small-cap mutual fund schemes, whereas a regular small-cap fund invests directly in small-cap stocks and FoF provides exposure to different fund managers and investment styles through a single scheme.

However, it is also important for investors to consider that FoF comes with an additional layer of costs with the expenses of the FoF as well as the expense ratios of the underlying small-cap mutual fund schemes and over the long term, these multiple expense layers can have an impact on the investor's net returns, Kumawat further said.

Investment strategy and portfolio construction

The fund house said that one should consider this small cap FoF as it will have active and professionally managed exposure without the burden of ongoing selection and monitoring, it will avoid investing biased by popularity or recent performance, it will have professionally managed, diversified holding, reducing the urge to switch or chase performance and will have a reliable, pre-packaged, tax-efficient solution for investors without hiring a dedicated manager research team.

The portfolio is expected to hold approximately three to six underlying small-cap funds at a time. This is intended to be broad enough to diversify manager and style risk, yet focused enough for each selection to contribute meaningfully. Allocations will be reviewed regularly and may be increased, reduced or replaced as the evidence changes. The scheme is proposed to invest in direct plans of underlying small-cap funds.

How to assess performance of underlying small caps?

Kumawat said investors should not assess the fund purely on the basis of their past returns and instead one can consider the consistency of performance across market cycles, risk-adjusted returns and its ability to manage downside risk during uncertain markets.

“In the case of an FoF, investors should additionally look at the overlap and complementarity among the underlying funds as holding several funds with similar portfolios or investment styles may provide limited additional diversification.”

Therefore, the quality of the underlying schemes and how differentiated they are from one another are more important than simply increasing the number of funds, he further said.

Pathak said that investors should not look only at past returns; consistency across market cycles, downside management, fund-manager experience, portfolio overlap and risk-adjusted performance are more important when evaluating the underlying funds.

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Key risks and opportunities of investing in small cap FoF

The objective is not to identify a single fund that will always rank first—an outcome that is unlikely to be sustainable. Instead, the strategy seeks above-average, risk-adjusted outcomes with greater consistency across market cycles. If the approach works as intended, the portfolio may avoid the extremes of the category and exhibit lower variability in alpha than an individual underlying fund.

According to the fund house, the important risks and considerations include that small-cap securities and funds can experience sharp price movements, liquidity constraints and prolonged periods of underperformance. Diversification across managers can reduce concentration risk, but it cannot eliminate market risk or guarantee smoother returns.

The fund house further said that the scheme bears fund-of-funds costs and is exposed to the performance, liquidity, processes and operational risks of underlying schemes and also the manager selection, allocation and rebalancing decisions may not produce the intended results.

While mentioning the benefits of investing in this FoF, the fund house said that the fund provides exposure to multiple investment styles and decision making frameworks, rather than reliance on one fund manager and a dedicated team performs quantitative analysis, qualitative due diligence and direct engagement with underlying managers.

One scheme can replace the need to select, track and rebalance several small-cap funds independently, investors can continue a single SIP while the fund of funds manages changes among underlying schemes and combining complementary managers may reduce the volatility of relative performance compared with relying on one small-cap fund.

Pathak said the biggest advantage is diversification across multiple small-cap managers and investment styles, which can reduce dependence on a single fund manager. However, the underlying exposure remains small-cap, so volatility and liquidity risks remain high, and investors should also consider the additional layer of costs in an FoF.

Kumawat said small-cap FoF provides an opportunity to diversify across multiple small-cap fund managers and investment styles through a single investment. However, investors should also consider that it is associated with multiple challenges where there is also a possibility of portfolio overlap, where different small-cap funds hold similar stocks, limiting the actual diversification benefit and FoF invests in other small-cap mutual funds rather than directly in stocks which attracts additional cost layer because investors bear the expenses of both the FoF and the underlying schemes.

Therefore, investors are suggested to invest in active small-cap funds directly along with diversifying across active diversified funds with market cap mix of 55:23:22 across large, mid and small caps which helps to reduce concentration risk and ride across market cycles without additional FoF expense layer, he further said.

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Suitability and small cap volatility

The scheme may be relevant for investors seeking long term exposure to the small-cap category who prefer professional selection and monitoring of multiple active funds within a single vehicle. It is better suited to investors with a long investment horizon, the ability to tolerate substantial volatility and a portfolio allocation appropriate for a high-risk equity product.

The fund house also highlighted that small cap witnesses deep draw downs of 25-30-35% practically once in every 3-4 years and demonstrates wide amplitude of returns - high risk of mistiming and drawdowns for retail investors, WhiteOak has high exposure to small caps and has a history of demonstrated alpha generation across funds and by launching a smallcap FOF, WhiteOak is not bringing yet another small cap fund; rather attempting innovation to improve outcomes for retail investors in a popular yet tumultuous space.

Kumawat said currently, broader markets appear relatively more attractive following the recent correction, with negative froth 12 to 14% across the market-cap segments. Within this, small caps have delivered strong earnings momentum, with Q1 earnings growth of 37% YoY which provides a supportive fundamental backdrop, and we expect earnings growth to remain healthy with attractive valuations.

“However, we suggest avoiding investing solely in the small-cap segment as investing in a single market-cap exposure can increase concentration risk. Instead, investors can consider diversifying across market caps, with an allocation of 55:23:22 across large, mid and small caps. Such diversification can help balance the higher growth potential while maintaining relative stability and liquidity and helps to ride across market cycles,” Kumawat further said.

Pathak said small caps continue to offer long-term growth opportunities, but valuations are not uniformly attractive after the strong run. I would prefer selective and staggered allocation rather than chasing recent performance, with a 7+ year horizon and for most investors, small caps should remain a part of the equity portfolio rather than become the core allocation.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)

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