Investors start to shun small and midcaps, but then fall for another poor idea

The amount of money flowing into small cap and midcap funds has declined significantly (down 20%).  (iStock)
The amount of money flowing into small cap and midcap funds has declined significantly (down 20%). (iStock)

Summary

The amount of money pouring into equity funds (all equity funds), is growing rapidly. It’s up 2.5x between June 2023 and January 2024.

Small caps and midcaps are hot. Large caps are not hot. Therefore, it is not surprising that money is chasing hot segments of the markets. These are facts you and me can agree on – if you are in any doubt, revisit any conversation about investing with your friends, family, or broker! Enough has been written and published on this. Having said that, there is an underlying trend which has not got due attention. And it’s quite a revelation.

Take a look at this table, which shows the % of total net flows into equity funds:

 

Total net flows into equity funds
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Total net flows into equity funds (contramoney)

Before we dig into this table, here are some definitions.

Racy funds here refer to purely smallcap, midcap and the sectoral/thematic schemes (this is where the new favourites, the PSE funds fit in).

Flexicaps are the funds which are classified as Flexicaps, where the fund mangers have a lot of flexibility on what to do with money.

And finally, the large cap funds are just that – purely large cap, as defined by the regulator. So much so, I have not included the “large and midcap" fund schemes here.

The table throws up broadly three trends.

First, the amount of money pouring into equity funds (all equity funds), is growing rapidly. It’s up 2.5x between June 2023 and January 2024.

Assuming people are selecting mutual fund schemes well, and in line with their planned asset allocation, this should be good news. Professional fund managers are generally better at investing than novice individuals. (I say this with a lot of caveats, which we will revisit in future editions of Contramoney.)

This leads us directly to the second point. Surprisingly, in spite of all the euphoria, the share of the total net inflows going into the racy funds, while high, has broadly declined over this period. January 2024 in fact saw a sharp fall. This is good news.

Having said that, investors are still overweight on racy funds. Typically, such allocations should not exceed 10% to 15%. Of course, this could vary depending on your appetite for risk, but even then, there is perhaps a point beyond which it gets too risky.

One other aspect of this racy fund allocation is that there is a big shift within. So, if you compare the flows of the last two months, with the previous two months, here’s what you will find:

The amount ofmoney flowing into small cap and midcap funds has declined significantly (down 20%). And on the other hand, the fund flows into thematic/sectoral funds have increased dramatically (up over 80%). I am sure you can guess the themes and sectors that are pulling in all the money!

Here’s what the Economist has to say on such sectoral/thematic funds:

In 2022 Itzhak Ben-David, Francesco Franzoni, Byungwook Kim and Rabih Moussawi, four academics, published research suggesting that thematic equityETFs, which attempt to track a narrow industry or trend, underperform broaderETFs by about a third over the five years after their launch. That is because of a straightforward problem: when thematicETFs get going, the buzz around the investment is already extensive and the underlying assets are already pricey.

In effect, while the retail investor may have got one thing right – incrementallyreduce exposure to small and midcaps, she has pivoted to investing in another poor investment idea i.e. sectoral/thematic funds.

The third takeaway from this chart is encouraging. Flexicap and Large cap funds have seen a large turnaround in money flow fortunes. Flexicaps have now seen positive net flows for some time. Large caps on the other hand have seen a sharp turnaround in their “money flow" fortunes from the troughs.

This is good news. If you selected your fund management team well, Flexicap is the way to go. Give them the money, and then let them decide where to invest. Don’t straight jacket them into investing in one way or another.

And large caps, it is common knowledge, perhaps offer the best value proposition in many years. By opting for large caps, you are in effect shifting from a pricey market to a relatively much cheaper market. It’s a low hanging fruit!

In all, the trends are encouraging though I hasten to add that there is still a long way to go. And given we are in a solid bull market this may be the best time to get started on the two main tenets of becoming a successful investor:getting your asset allocation right and then ensuring youposition size your investments well.

 

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477.

You should always consult your personal investment advisor/wealth manager before making any decisions.

 

 

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