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Should you increase allocation to mid cap, small cap mutual funds?

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The broader mid and small cap indices have recovered in the last few months after going through a rough patch for more than two years in a row. From the start of the calendar year, Nifty Index is down 7.5%, BSE Midcap Index is down 5.2% and BSE Smallcap Index is down just 0.8%. And from March lows, Nifty Index is up 47%, BSE Midcap Index is up 47% and BSE Smallcap Index is up 54%. Does it signal revival in these segments?

“Midcaps and especially smallcaps have done better than the large caps inspite of general belief that in uncertain times like these it would be the largecaps which would have done better than smallcaps. So one can clearly see that the mid/smallcaps space is bouncing back,” says Aditya Khemani, Fund Manager, Motilal Oswal AMC.

Positive trends are reflecting in mid- and small-cap mutual funds space as well. One-year returns of mid cap and small cap funds have recovered from being in double-digit negative till a few months ago to 9.33% and 8.48% respectively. In the last three months, the mid cap mutual fund category has delivered an absolute return of 22.98% and small cap has grown by 28.95%.

Mutual fund analysts believe the segments now provide a good investment opportunity.

“Since the last quarter of 2013 till 2017, mid and small cap segments haven’t really witnessed any major correction and were richly valued. From this perspective, the recent correction in both the segments provided an attractive investment opportunity for investors,” says Himanshu Srivastava, Associate Director – Manager Research, Morningstar India.

Mid cap and small cap mutual funds have severely under performed large caps in over last two years. There have a few roadblocks like problems in the financial markets after IL&FS crisis, teething issues due to GST rollout and finally Covid related economic disruption thereby slowing the economic growth.

“As the economy slows mid/smallcap company’s ability to withstand the economic shock is relatively lesser versus the large cap companies. Hence their business becomes more volatile, their cash flows are impacted which in turn impacts their earnings growth and hence their valuation and stock prices,” says Aditya Khemani.

BSE Midcap index after hitting a high in January 2018 is down 22% since then. Similarly BSE Smallcap Index is down 32% since then but at the same time Nifty is up around 5%.

Should mutual fund investors invest in mid cap and small cap funds now?

Mutual fund managers believe it is apt time for investors to build their mid and small cap portfolio. But they alert investors not to get overboard with these investments and advise to stick to the desired asset allocation.

“For investors who have the stomach for the risk associated with mid and small cap segments, this an apt time to build , while sticking to their suggested asset allocation,” says Himanshu Srivastava.

Srivastava adds, “During challenging investment environment, mid and small caps typically fall more than their large cap counterparts as has been the case in 2018, 2019 and in the earlier part of 2020. This makes them a strictly long-term investment option.”

However some mutual fund managers also believe that choosing one category over the other may not be a solution in these markets. There is no rule for out performance now. Any individual large cap can outperform any individual mid cap or vice versa.

“We have observed in the last 2-3 years that a good quality mid cap and small cap’s performance is equivalent to a good quality large cap. There is no rule for out performance in these markets. I don’t see risk-reward being favourable in respect of one category over the other. A diversified category will be a better solution for investors,” says Shreyash Devalkar, Sr. Fund Manager – Equity, Axis AMC.

Devalkar further explains, “mid cap index has lesser exposure to financial sector than large cap index. And in the last last one year financial sector has underperformed, this is one of the main reasons for the higher returns in mid caps than large cap funds.”

The benchmark large cap index BSE Sensex has over 36% in financial sector whereas, BSE Mid cap index has 20% in financials.

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