Why mid- and small-cap funds are the talk of the town

TCS on overseas payments for investments such as buying stocks and mutual funds to attract more tax over the prescribed threshold limit. (Pixabay)
TCS on overseas payments for investments such as buying stocks and mutual funds to attract more tax over the prescribed threshold limit. (Pixabay)

Summary

The relentless flows in mid- and small-cap funds and soaring valuations in this segment is making the industry body of asset managers anxious. But in the event of a redemption rush, funds may have some cash and large-cap cover for now to stay afloat.

Amidst all the rage for mid- and small-cap investments in recent years, a sense of nervousness is palpable. Impressive returns in the past have led to frenzied interest from retail investors in this space. As a result, the segment is showing some signs of overheating, which some fear could trigger a correction in the near term. Taking cognizance of the situation, the Association of Mutual Funds in India (Amfi) has requested fund houses and managers to take preemptive steps to safeguard investors. Some have already started implementing corrective measures. Mint takes stock of the mid- and small-cap mutual fund (MF) schemes and examines how they are placed for the time when the tide turns.

Problem of plenty

Mid-cap and small-cap funds have lately been a prime destination for retail money invested through equity schemes. Such funds received 42% of the total inflows into domestic equity MFs in the first 10 months of 2023-24, up from 30% in 2022-23.

Frothy valuations

Amidst this euphoria, fund managers have their task cut out to spot the gems. In their search for newer investments, they have been lapping up more small-cap stocks than mid-caps. Yet, limited information about the small-cap space leaves a very limited basket available for investment. With all the money chasing a limited set of stocks, rising inflows have set valuations soaring in some pockets, which could get worrisome going ahead.

“From a valuations perspective, investors' behaviour is important from two aspects," said Kaustubh Belapurkar, director (fund research) at Morningstar. “One, they must have realistic expectations, which means knowing that if a fund/market segment has performed well in the past, it may not continue to do so with the same magnitude in the near future. Second, have the right time horizon and in situations like this (where markets have run up significantly), it is always good to have a longer time horizon."

Pressure points

Inflows have also fed into the prices of mid-cap and small-cap stocks. Both the Nifty Midcap 150 and Smallcap 250 indices have risen stupendously, by over 50% in the fiscal year so far. However, the big gainers in these categories have often been the ones with inadequate free float component (i.e. a small pool of shares available for trading by the public). This could put fund houses at liquidity risk in the event of any steep redemption pressure.

 

What’s plan-B?

An MF categorized as mid-cap or small-cap must invest at least 65% of its portfolio in that respective category of stocks. So in a liquidity crisis, what a mutual fund scheme holds in the residual part of its portfolio will come into the picture. Their cash holdings are decent currently, but leaving too much money undeployed is not ideal either. A partial diversion towards large-caps (which are highly liquid) could help, and some funds have already increased their exposure to them.

 

“Mid-cap and small-cap schemes are utilizing a combination of cash and large-caps for protection against any potential redemption pressures," said Nirav R. Karkera, head of research at Fisdom. “Most funds are doing a pretty decent job in maintaining adequate cushion in terms of catering to this liquidity need." However, some small-cap funds with significant exposure to microcap stocks and limited exposure to large-caps and cash could remain at risk.

 

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