Should you invest in smallcase portfolios

Smallcase has captured the imagination of the retail investor. But should you invest in a smallcase portfolio? How should you evaluate a smallcase? Let’s see if we can find some answers.

Based on Business Today article dated Dec 2020, there were 2 million users and over Rs. 50,000 crores of transactions executed via the platform then. 

Not just investors, popular fund managers and successful investors are now using the platform to offer custom portfolio strategies to a set of investors highly interested in trying ‘this new’ way of investing.    

What’s the reason for this interest?

If I were to put one reason behind the roaring success of smallcases are serving the big question investors “naya kya hai” or “What’s new”. These are the same investors who throng IPOs for listing gains too.

With smallcase, the idea is stretched further, a quick win to make money from a trend/theme. This belief was cemented due to the stupendous returns in the wake of the bull market in the last 2 years. 

It’s a heady cocktail.

Hmm. But we are getting ahead of ourselves.

First things first…

What is a smallcase?

“smallcases are portfolios of stocks or ETFs, weighted intelligently to track a theme, strategy or objective.”

That’s how the smallcase website puts it. Basically, you can think of anything, literally, and create a list of holdings from the entire universe of stocks/ETFs. This portfolio reflects your thinking.

Take some examples of portfolio titles on smallcase 

• Brand Value
• Rising Rural Demand
• Green Energy
• Listed Venture Capital
• All Weather
• Magic Formula
• And the most popular category amongst all – Momentum. 

At the speed at which they are coming up, there are likely to be thousands of smallcase portfolios in the near future. There is a smallcase for everyone (actual marketing byline of smallcase).

You can imagine the ‘mela’ investors get to enjoy. 

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How should you evaluate and invest in smallcase, if at all?

Let me share my personal approach towards smallcase.

1. Know thy enemy. Smallcases are very individual driven strategies. In most cases, the managers had personal success in the past with their specific portfolio strategy and they now offer it to other investors. There are no regulation on the construction of these portfolios. You have to keep this aspect in mind. I would go further to say that invest in only those strategies where you know the manager personally. If you don’t, take time to do that. Read their articles, see their videos, interact with them on emails, attend webinars, get aligned to their way of thinking, the approach, before you take the call. This may take 6 months or 1 year, so be it. 
2. The devil lies in the details. When you are looking at a strategy, check for all the details. Go beyond the returns. Is the primary aim to grow capital or to protect capital? Is this large cap or small cap or asset allocation based? Are you okay with the aggressiveness of the strategy, the time horizon, rebalancing frequency, fees, etc. If your smallcase manager is not indicating, can you make the calls about entering and exiting a particular theme/tactical portfolio? 
3. Discount the cash flows returns. When you look at returns, use a simple thumb rule. “What if I end up getting only half the returns currently showcased for this smallcase?”. We all know that what has worked in the past, may not work in the future. Discount that fact in your expectations. The is specially true for recent high performance, which could purely be because markets moved up significantly over the last 2 years.  
4. Don’t stand on one leg. Don’t let any one smallcase be the only strategy in your portfolio or a significant allocation. You can start small and increase your allocation gradually. Keep an upper limit of say 5%, 10% or 20% for allocation. 
5. Watch the exit door. If at any point, you don’t feel comfortable with the approach or the answers, simply exit . Let me repeat, uncomfortable with the approach, not the current returns.   

What is the current experience of smallcase investors?

If you go by several reports (tweets/blogs), it may seem that it has not been entirely pleasant. 

Many people come out disappointed with small case. It is important to know why?

I think they end up comparing it with MFs (passive, active), PMS, etc. As also, the desire to make a quick return which does not play out in reality. 

There is a huge gap in expectations vs reality.

Let’s look at a few of these gaps and how to address them. 

#1 Smallcases are not alternatives to mutual funds. Both have a different role to play. 

Know that most small cases are very focused strategies, with sometimes as much as 5 to 15 stocks in the portfolio. In comparison, you won’t find any mutual funds scheme with that concentrated an exposure. 

I would suggest that you get a firm view on what is the required time horizon of the strategy. 

You may note, for example, that Parag Parikh Flexi cap fund clearly mentions not to invest in its fund, if you won’t stay for 5 years. 

Do you check what is the minimum time horizon prescribed by your smallcase strategy? Unlikely.

In fact, some of the smallcase managers intend to benefit only from  current headwinds in a sector / theme (housing, EV, digital, etc.). This is the equivalent of sectoral/thematic funds in mutual funds.

Such ideas can only get a tactical and limited allocation in the portfolio with a clear exit based on time. Sooner or later, these themes dissipate their attractiveness and you are likely to pay a price if you overstay. Be mindful.   

#2 Investors end up looking at past returns and invest 

This is no different than what an investor might do with any other investment. Yet, there is more to it than meets the eye. 

The Backtests.

“Mirror, mirror, who is the most beautiful of them all?”

I am sure you have read this or some person of this. You probably get the idea too. Most smallcases use models which are backtested. Let me just add this statement from Taleb, the author of “AntiFragility” and “Fooled by Randomness”.

All models are wrong, some of them are lethal.

When you see past returns of a newly launched portfolio on smallcase, those returns are most likely wrong. In my personal experience, smallcase does not allow uploading of backtest data. It simply interpolates the current portfolio to the past and shows the result, whatever it is. That is not fair to the strategy, but that’s how it is. Managers, usually, add article links to share more details about their strategy. You must refer to that. 

Having said that, actual performance will differ significantly from back-tested performance. Back-tested results usually are not adjusted to reflect the reinvestment of dividends and other income. They also do not include the effect of transaction timing / execution costs.

#3 The difference in the model returns and actual returns 

Then is the question of returns… investors in the portfolios on smallcase tend to feel that the displayed returns and the actual returns that a user gets are very different. 

Well, they are most likely going to be. Your actual order execution date, time and type of security (liquidity) will determine your portfolio returns. You might buy/sell at different prices. You may rebalance at a different time than the model portfolio.

Capital Gains taxes or setoffs, if any, are also not factored in the smallcase returns. Then there is the fee you pay for accessing the advice, which could dent your returns seriously. 

#4 Do they really outperform?

There is also an issue of comparing strategies with the right benchmarks. For example, a momentum strategy should ideally be compared with the Nifty 200 Momentum 30 Index while on smallcase it is compared with the large cap or Nifty 500 index. Fair point and a valid criticism. 

However, you can always choose to compare returns with a different benchmark or a mutual fund scheme for that matter. 

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Let me invert and say who should NOT invest in a smallcase

1. Don’t have an investment plan – Why are you investing, what’s the kind of risk you are willing to take, what allocations to various asset classes work best for you? What money will you expose to building wealth and what to protect? Do you need play money – how much?
2. Afraid of rollercoaster – If you are not someone who is willing to go on up and down ride (volatility). A portfolio can start strong as the markets thrive but when markets start going down, the portfolio can look battered. This has nothing to do with the quality but only the short term market temperament. This is further accentuated due to the holding concentration in the portfolio (remember 5, 10 or 15 stocks). 
3. Small investor – Smallcase fees are not small for the retail investor. If you are not someone who can make a large investment, think 10 times. Imagine, making a commitment of Rs. 1 lakh lumpsum or Rs. 10,000 SIP in a smallcase with a fee of Rs. 15,000. You are paying about 10 to 15% in fee. The downside of this is it will mess up your brain as your expectations of returns will go up dramatically so that  you can justify the fee. In most cases, that does not happen.   
4. No time – Smallcase portfolios may tend to churn a lot specially the momentum strategy kinds where the changes could be required weekly or monthly. You will get an alert alright, but you need to follow through with a timely action to be able to benefit. I remember someone telling me that they were on a retreat when the change came in and by the time they could act, the price of a particular stock had already doubled. It can be the reverse too. Phew!  If you can’t take timely actions, this may not be the right way to invest for you.
5. Hate tax reporting – All these frequent actions can also read to tax reporting headaches too. If you have someone who takes care of this, fine, but the small investor may end up adding another layer of cost in hiring someone to sort out the tax reporting. Will you be ready for that?

I know I am asking you to do a lot of work But that’s how it is. This is the way to move safely through the smallcase portfolio jungle. 

When you see a knife, how you hold it and what you use it for makes it a tool or a weapon. 

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Unovest also has ETF based on smallcase for 1 simple reason – convenience. It offers an end to end provide system to provide advice and execute the portfolio with a click of a button. Rebalancing alerts can be triggered to investors which they can complete again in a single click. 

Between you and me: What is your experience with smallcase? How do you find the right one for you?