Should you allocate more money to small and mid-cap funds?

Gains from the large cap funds seem to have moderated. Mid and small cap stocks look poised for a run up. Investors could consider the mid and small cap funds category.

Kavya Balaji   /   November 3, 2020
Should you allocate more money to small and mid-cap funds

If you look at 2018 and 2019, mid cap and small cap mutual funds had severely underperformed large caps. The main reason behind this was the crisis after crisis in the financial markets starting with the IL&FS problems, the Goods and Services Tax (GST) rollout by the government and then came the pandemic related economic mess up. Slower economic growth meant slower business for mid and small cap companies when compared to the large cap ones. So, these businesses become more volatile, their balance sheet gets affected and the company cash flows are impacted. This means that the earnings growth of mid and small cap companies will be lower and hence the valuation and stock prices will fall.

This underperformance of the mid and small cap stocks segment is almost cyclical. If you look at 2013- 2017, since the end of 2013 till 2017, mid and small cap stocks did not see any major corrections and were richly valued. Since January 2018 till the end of the lockdown in 2020, mid cap and small cap indices had seen a sharp pull back while the broader markets have underperformed. During that time, more than 85% of the top 1000 stocks in the market had fallen by more than 50% while more than 500 stocks had corrected by 60%. The downturn during these 2 years has been one of the longest and deepest falls, especially for small cap stocks.

Getting back on track

However, things started changing in July-August once the economic activity started resuming in the country. Midcaps and especially small cap stocks have done much better than the large cap ones. So, one can clearly see that the mid/small cap space is bouncing back.

This is obviously a plus for mid and small cap mutual funds. One-year returns of mid cap and small cap funds were in double-digit negatives at the start of 2020. Now the one-year category average is much more than 10% for mid cap mutual funds while small cap mutual funds have provided returns of over 13% in the past year. In the last three months, the small cap mutual fund category has given an absolute return of over 17% and the mid cap category has provided 10%. So, these segments now provide a good investment opportunity for those who have a higher risk appetite and are looking to make more returns from mutual funds in the long term.

So, whats happening with large caps?

The large cap funds segment is not seeing much action. The one-year category return for large cap funds is just about 1.9% while the three-year return in this category is only 5%. So, the present deviation between performance of large, mid and small cap funds is at historical highs. The valuations of mid and small cap stocks when compared to the Nifty is now close to the lows that were seen in 2014. Such deviations in returns dont last for too long, especially once the mid and small cap stocks have started to outperform large caps. Mutual fund analysis believe that this trend might continue over the next 18-24 months.

What are the market indices signaling?

The BSE Midcap index after reaching a high in January 2018 is down by 2.4% in the last 3 years while the BSE Smallcap Index is down by 3.9%. At the same time, the BSE 100 Index has increased by around 4.25%. However, when you look at the one-year return, things are different. While the BSE 100 has provided 1.3% in the past year, the BSE Midcap index is up by 4% while the BSE Smallcap Index has gone higher by more than 14%. This shows a trend reversal in the mid and small cap stock segments.

So, fund managers believe that this might be the right time for investors to build their mid and small cap portfolio. However, it is best not to go overboard with these segments as the risks are much higher. Investors should stick to their desired asset allocation strategy and consider their risk-taking capacity before investing in mid and small cap funds. You need to stick to them for the long term if you want good returns. Dont know which are the right mid and small cap mutual funds for you? Get help from wealthzi.com.

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