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Three years ago, mid and small caps had a 2017 dream run. The Sensex Small cap – TRI index returned 60.8% during the year; Sensex Mid cap – TRI index wasn't far behind, delivering 50% returns. Consequently, mid and small cap funds turned out to be an exciting investment avenue.
The top performing mid cap fund and small cap fund during that period generated an astounding 53.7% and 80.4% absolute returns, respectively. Unfortunately, most investors who entered the segment post 2017 with hope of riding the bull-run received nothing but pain in return.
Since the beginning of 2018, mid and small caps have corrected sharply - Sensex Mid cap – TRI index is down 13.3% (in absolute terms). The correction is steeper in case of small caps as the Sensex Small cap – TRI index is down by 25.3%.
[Read: Are Your SIPs Giving Negative Returns? Here's What To Do...]
The fall could be attributed to the multiple shocks the segment has been facing. First, SEBI's categorisation norms for large, mid, and small caps made smaller caps less attractive for investors. Second, as the fortunes of mid and small caps are closely tied to economic growth, the prolonged slowdown in the economy has impacted the growth opportunities. Besides, difficulty in raising credit due to the liquidity crisis in NBFC sector has amplified the pathos.
Mid and small caps are high-risk high-return investment avenues. This means they have the tendency to go from thrilling highs to dangerous lows. Moreover, due to the limited access to various resources, smaller companies are associated with multiple risks. The liquidity risk associated with them, as the limited number of shares, makes it difficult for investors to buy and sell as per their wish.
That said, a strong business helmed by a well-built management team along with the availability of stock at a reasonable price can make it a very attractive investment proposition.
Table 1: Performance of mid cap funds in the last five years
Data as on January 10, 2020
(Source: ACE MF)
During the correction phase, various mutual funds in mid as well as small cap category rewarded investors by adopting a careful stock picking approach and stringent risk management techniques. On the other hand, some schemes performed poorly even during the longer time horizon.
Table 2: Performance of small cap funds in the last five years
Data as on January 10, 2020
(Source: ACE MF)
But the good news is that the crash in mid and small cap segment has made valuations in the category attractive. This has provided fund managers a valuable opportunity to pick quality stocks with strong fundamentals that have the potential to grow in time.
Graph: Valuations in large and midcaps
Data as on January 10, 2020
(Source: nseindia.com)
Mid caps are currently trading at a P/E of around 25 times, down sharply from its peak valuation of around 60 times in 2018. This makes it a good time to invest in the segment. Meanwhile, large caps continue to rally despite trading at high valuations.
Despite volatility, equity markets have the potential to bounce back. In the past, the market has been through multiple bear phases, including the global financial crisis of 2008, but it has still managed to grow manifolds over the years.
Graph: The broader market has grown manifold over the years
Data as on January 10, 2020
(Source: ACE MF)
The measures undertaken by the government and RBI to reinvigorate economic growth and more measures that are likely to be announced in the upcoming budget can prove to be beneficial for smaller-sized companies.
However, one cannot expect a sharp recovery as the measures undertaken may take time to show results at grassroot level. Added to that, rising inflation, geopolitical risks, etc. may heighten volatility in the near term.
So if you are looking to invest in mid cap funds and small cap funds in 2020, invest only if you have a long term investment horizon.
[Read: The Special Care to Select the Best Mutual Funds in 2020]
It is difficult to ascertain when the tides will turn in favour of mid and small caps and whether large caps will be able to sustain rally given the difficulties the economy is facing. Thus, it makes sense to diversify your portfolio across market caps to reap the maximum benefit of changing market conditions.
By diversifying your investment, you benefit from the stability of the large caps and high growth potential of mid and small caps. But make sure to invest in worthy schemes that fare well on quantitative and qualitative parameters.
The schemes that you choose must be managed by experienced and competent fund managers and belong to fund houses that have well-defined investment systems and processes in place. Each fund should have performed consistently well across market phases and cycles in comparison to their respective benchmark and category peers and rewarded investors with superior risk-adjusted returns.
[Read: Selecting Mutual Funds Carelessly Can Cost You Dear]
Even though the mid and small caps may shine in the future, do not increase your weightage in the category without evaluating your needs. A top performing scheme or category of the past year may not be the top performer in the following year. So stick to your personalised asset allocation plan based on your financial goals, risk appetite, and investment horizon to avoid undue risk.
Opt for systematic investment plan (SIP) to grow your wealth through the power of compounding and that too at lower risk. And finally, review your investment at regular intervals to ensure you're on the right track to accomplish your envisioned financial goals.
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