Should You Consider Investing in Mid-cap Funds and Small-cap Funds Now?

May 25, 2022 Mutual Fund

Mid-cap funds and Small-cap Funds lost significant values over the last few months owing to the sharp volatility in the equity market. In the last one month, Mid-cap Funds saw a decline in returns of around 8%, while Small-cap Funds fell by around 8.5% on an average. On the other hand, Large-cap Funds fared slightly better with a return of around -6%.

This is in sharp contrast to the mutual fund returns seen between 2020 and 2021, wherein Mid-cap Funds and Small-cap Funds outperformed Large-cap Funds by a remarkable margin.

Notably, a large number of mid-cap and small-cap stocks have entered the bear grip as they are down by around 20% or more from their life-time highs.

Table 1: Mid-cap Funds and Small-cap Funds on a downward trend

Data as on May 23, 2022
Direct plan – Growth option considered. Past performance is not an indicator for future returns
(Source: ACE MF)  

Mid-cap Funds and Small-cap Funds could witness more pain ahead due to the following factors:

1) End of easy money

Central banks around the world spent heavily over the last two years to support economic growth amidst the COVID-19 pandemic. A significant chunk of this money flowed into the equity market. However, with economic activities improving, central banks, including RBI, have started to tighten liquidity measures. This has resulted in money flowing out of equity markets.

2) Persistent selling by foreign investors

Foreign Institutional Investors (FII) are among the big movers of the equity market. However, with the valuations in the Indian equity market at a multi-year high, FIIs have been relentlessly selling their holdings of Indian stocks. Since October 2021, FIIs have net sold to the tune of about Rs 2 trillion.

3) The Russia-Ukraine war

The Russia-Ukraine war is showing no signs of slowing down. Since Russia is a major oil-producing country, the sanctions on the country by some of the major world economies have impacted the production and supply of oil. Consequently, this drove oil prices to its highest level in nearly a decade. It is expected that rising oil and other input costs will negatively impact the profit margin of India Inc.

[Read: Mutual Fund Investment Strategy You Can Follow to Counter Equity Market Volatility]

Are valuations favourable now for investing in Mid-cap Funds and Small-cap Funds?

The S&P BSE 150 Midcap Index is down by around 15% from its all-time high, which it hit in October 2021, whereas S&P BSE 250 Smallcap Index is down by about 18% from its life-time high which it hit in January 2022. After the recent retracement, the mid-cap and small-cap indices are trading at an attractive valuation compared to the previous few months. This makes it a good entry point for investors looking to benefit from the high-growth potential.

That said, due to the aforementioned factors, mid-cap and small-cap stocks are likely to witness intensified volatility in the near future. Therefore, it is important to set realistic returns expectation and tread with caution.

Table 2: Valuations in the mid-cap and small-cap segments look attractive

(Source: bseindia.com)  

Who should invest in Mid-cap Fund and Small-cap Fund?

Mid-cap Fund and Small-cap Fund have a tendency to plunge more than Large-cap Funds during highly volatile and uncertain market conditions. However, they have the potential to outpace their large-sized peers by a noticeable margin over the long run.

Therefore, invest in Mid-cap Fund and Small-cap Fund only if you have a very high-risk appetite to withstand short-term losses and high volatility and an investment horizon of at least 5-10 years. Investors with low to moderate risk profile should completely stay away from Mid-cap Fund and Small-cap Fund.

The care to take when investing in Mid-cap Fund and Small-cap Fund

As you may know, past performance is not an indicator of future returns. Therefore, when you invest in Mid-cap Fund and Small-cap Fund, avoid chasing schemes based on their recent performance because the performance may or may not sustain in the future.

[Read: The Complete Guide on the Best Midcap Mutual Funds in 2022]

To select the best schemes, analyse if the fund has shown consistency in performance across various market periods (bull and bear market phases) compared to the benchmark and category peers. While all funds perform well during the bull phase, an important parameter when selecting a Mid-cap Fund and Small-cap Fund is to determine its ability to manage the downside risk during tough market conditions.

The next step is to determine whether the fund has rewarded its investors well for the risk they have taken using the risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

Give preference to those funds that stand strong on risk-reward parameters when you are short-listing funds for your portfolio.

Though the universe of mid-cap and small-cap stocks is very large, very few stocks in the segment, have the potential to grow steadily over the long term. This makes it important to invest in only those Mid-cap Fund and Small-cap Fund that focuses on selecting high-quality stocks in the respective segments.

This makes it important to select schemes from fund houses that have a significant performance record and follows robust investment processes with adequate risk management systems in place.

To conclude

When investing in mutual funds, it is important to create a diversified portfolio spread across market caps and sectors to reduce the impact of market volatility.

Even though Mid-cap Fund and Small-cap Fund underperform in the short run, they can significantly boost your portfolio returns if you choose to exercise patience. It is advisable to opt for the SIP mode of investment that will help you to reduce the risk to your portfolio and grow your wealth through the power of compounding.

This article first appeared on PersonalFN here