Market at All-time High: Is This a Good Time to Invest in Mid Cap and Small Cap Mutual Funds?

July 5, 2023 Mutual Fund

Mid Cap Mutual Funds and Small Cap Mutual Funds, the category of mutual funds that invest minimum of 65% of their assets respectively in mid-cap and small-cap stocks, has grabbed investors’ attention.

In the last three months, the Mid Cap Mutual Fund category generated average returns of 17.4% (as of June 30, 2023), while the Small Cap Mutual Fund category generated average returns of 19.1%, driven by a sustained broad-based rally in the equity market. The two categories outperformed the Large Cap Mutual Fund category average of 13.6%. Notably, the Nifty Midcap Midcap 150 index as well as Nifty Smallcap 250 index are currently trading at their all-time high levels.

Buoyed by the rally, investors poured money in these two categories. The Mid Cap Fund category received inflows to the tune of Rs 5,116 crore between March-May 2023, while the inflows in the Small Cap Fund category stood at Rs 7,895 crore during this period, much higher than most other sub-categories of diversified equity mutual funds.

Top-performing Mid Cap Funds and Small Cap Funds based on historical returns

Scheme Name	3 Months	1 Year	3 Years	5 Years	7 Years
HDFC Mid-Cap Opportunities Fund	20.79	43.43	36.59	17.62	17.58
Motilal Oswal Midcap Fund	19.03	39.46	40.47	19.62	16.98
Taurus Discovery (Midcap) Fund	22.60	35.26	28.13	15.01	16.13
Nippon India Growth Fund	20.00	34.32	36.39	19.18	17.74
Franklin India Prima Fund	17.18	33.60	28.27	13.70	13.79
Nifty Midcap 150 – TRI	19.29	34.40	34.68	16.89	17.33

HDFC Small Cap Fund	19.18	46.33	44.57	17.97	20.06
Franklin India Smaller Cos Fund	18.42	42.25	43.09	15.70	15.56
Quant Small Cap Fund	18.55	42.17	60.09	27.18	20.50
Nippon India Small Cap Fund	21.76	40.93	48.09	22.52	22.93
Tata Small Cap Fund	16.67	40.17	44.22	—	—
Nifty Smallcap 250 – TRI	21.94	31.48	38.57	13.88	13.55

Past performance is not an indicator of future returns
Data as of June 30, 2023
(Source: ACE MF, PersonalFN Research)

What are the factors driving higher gains in Mid Cap Mutual Funds and Small Cap Mutual Funds?

One of the key factors that boosted gains in the mid-cap and small-cap segments is the better-than-expected earnings growth. In addition, the resilient growth in the Indian economy, despite fears of a slowdown in certain major global economies, along with cooling inflation and the onset of monsoon, has worked in favour of smaller companies. Furthermore, the pause in rate hike action by the RBI and the expectation of a subsequent decline in interest rate benefits mid and small-sized companies as it will make it easier for these companies to raise capital.

Should you invest in Mid Cap and Small Cap Funds now?

Mid Cap Funds and Small Cap Funds invest in emerging businesses and niche segments, and therefore, they can potentially deliver higher returns in the long run compared to Large Cap Funds that typically invest in matured/established businesses. Thus, Mid Cap Funds and Small Cap Funds have the potential to outpace Large Cap Funds over the long term.

At present, several quality names in the mid-cap and small-cap segments are trading near their record-high levels. This implies that the margin of safety has narrowed. Even though the market could continue to rally for some more time, it is important to tread with caution.

Do note that Mid Cap Funds and Small Cap Funds are high-risk high-return investment avenues. During a market rally, even low-quality names that lack fundamentals begin to soar. Therefore, if the liquidity dries up, mid-cap and small-cap segments could feel the impact first.

When you invest in smaller companies, remember that for every high-potential stock, there is a long list of stocks that can turn out to be wealth destroyers. This is especially true for small-cap stocks. The small-cap to Sensex ratio is at 0.51 times, at a premium to average of 0.43 times, but still below the peak, according to data from Equitymaster.

Additionally, even a mid and small-cap stock that scores high on quantitative parameters such as operating margin, ROE, P/E, and P/B may still fail to reward investors if it is not run by a quality and competent management. Keep in mind that the Mid Cap Funds and Small Cap Funds can plunge lower than Large Cap Funds if the market sentiments turn negative.https://www.youtube.com/embed/fqPkNiWwe-k

Investment strategy investors may follow when investing in Mid Cap Funds and Small Cap Funds

Investors should consider devising a suitable strategy and take exposure in Mid Cap Funds and Small Cap Funds sensibly depending on their risk profile and financial goals.

Historical data suggests that no particular market cap can be an outperformer every year. Hence, diversification across market cap, viz. large-cap, mid-cap, and small-cap, is necessary. This will help lower the impact of volatility on your portfolio and thereby earn better risk-adjusted returns.

However, since Mid Cap Funds and Small Cap Funds are high-risk high-return avenues, they are only suitable for investors having a high risk appetite.

Furthermore, investors should avoid investing in Mid Cap Funds and Small Cap Funds with a short-term view. Only investors who have a long-term investment horizon of at least 5-7 years and the aptitude to handle severe drawdowns may consider Mid Cap Funds and Small Cap Funds.

Mid-caps and small-caps can outpace large-caps in the long run

Past performance is not an indicator of future returns
*YTD as of June 30, 2023
(Source: ACE MF, PersonalFN Research)

For better safety, prefer only those Mid Cap Funds and Small Cap Funds that focus on picking quality stocks in the mid-cap and small-cap segment instead of chasing momentum-driven bets. For this, a detailed evaluation on quantitative parameters (past performance, risk-return matrix) along with qualitative parameters such as the fund manager’s experience and the portfolio characteristics of the scheme is necessary.

When selecting schemes for the investment portfolio, avoid relying excessively on a fund’s past performance; a top-performing scheme of the past year may not be the top performer in the following year. Remember that the important factor when selecting any scheme is to evaluate the consistency of a fund’s performance based on quantitative and qualitative parameters.

[Read: How to Compare Mutual Funds]

Mid Cap Funds and Small Cap Funds can form part of the Satellite portion of their mutual fund portfolio where the combined allocation does not exceed 25-30% of the assets. Additionally, investors may prefer the SIP mode of investment to reduce the impact of volatility and benefit from the power of compounding.

If the financial goal for which the investors have invested is nearing, they can trim exposure to Mid Cap Funds and Small Cap Funds. Gradually shift exposure to less risky and stable categories such as Large Cap Funds and subsequently to safely managed debt mutual funds and/or bank deposits, etc.

Investors with a moderate risk profile looking to take meaningful exposure in the mid-cap and small-cap segments can consider investing in Multi Cap Funds, Flexi Cap Funds, or Large & Midcap Funds. These funds invest across the market cap and are less risky than pure Mid Cap Funds and pure Small Cap Funds.

The Investment Strategy Mutual Fund Investors May Follow as Sensex, Nifty Touch Record Highs

This article first appeared on PersonalFN here