Small and mid-cap funds are overvalued. Investors must tread carefully and examine certain parameters before investing in a suitable mutual fund scheme

Not all investors look for safe-haven. Some have a penchant for taking risks for potentially higher returns.  Investment in small and mid-cap mutual funds can provide just that, albeit at a higher risk. As the name suggests, small and mid-cap funds invest in companies with lower market capitalisation than large companies; and the proportion of investments between mid-cap and small-cap may vary from fund to fund. A mid-cap company’s market capitalisation would range anywhere between two billion dollar to $10 billion; whereas a small-cap is a company of market capitalisation between $300 million and two billion dollar.

In a typical growth curve of companies, large companies are at the top end of the curve; whereas mid-cap companies are in the middle, and small-cap at the beginning. Still, in the growth phase, mid-cap companies are expected to have higher growth and increase their profits, market share and productivity. They are riskier than large companies but less risky than small-cap companies. On the other hand, small-cap companies offer investors more room for growth but also confer greater risk and volatility than both mid-cap and large-cap companies.

Although the Nifty and Sensex are on a rise for a major part of the year now, the small and mid-cap index has underperformed in both the indices. However, if an investor takes a long-term view of 10 years, historically, small and mid-cap funds have outperformed the large-cap funds — the latest example being a whopping 55 per cent return in 2017.

However, volatility is the middle name for small and mid-cap funds. Although annualised returns for the last five years have been very high, one can also witness huge downsides for a brief period of time. For instance, the first half of 2018 had seen a tough phase for small and mid-cap mutual funds and these schemes were badly hit. Mid-cap category gave an average return of -5.63 per cent and small-cap schemes generated -7.75 per cent in the six-month period. Reasons for this lacklustre and almost frightening performance are many.

After the re-categorisation of mutual fund schemes by SEBI, several Asset Management Companies (AMC) sold off their small and mid-cap holdings along with many large institutions,  which moved their investments to large caps. These sell-offs, along with other macroeconomic factors, like rising crude oil prices, falling rupee, falling interest rates, political uncertainty and FII sell-offs, are putting the burden on mutual funds. The downside is small and mid-cap will continue as they are overvalued and further corrections are expected, thereby prolonging the pain in small and mid-cap sector for some more months to come. This is the reason why investments in small and mid-cap funds are not for everybody — it is only for investors who have the stomach to digest the volatility.

Investors should examine certain parameters while investing in small and mid-cap funds. The first criteria is the construction of a portfolio with quality stocks and lower turnover ratio. Past performance of any fund, both in bull and bear runs, is also important to find a mutual fund with consistent returns. A small and mid-cap fund with a price-earnings ratio of less than 30 is acceptable. Any value higher is considered risky.

Quality of the asset management company and its investment process is also crucial for any investor. An investor’s ability to switch between small, mid and large-cap companies, depending on the market conditions or to hold cash, also makes for a good mutual fund. As investing in small and mid-cap requires experience, and above all, precise qualitative analysis, the advice of an experienced and a prudent fund manager goes a long way in selecting a fund.

Aggressive investors should focus on mutual funds that have invested in growth-oriented small and mid-cap companies that have delivered consistent returns in the long-term, with an investment horizon of not less than five years. Small and mid-cap funds should be chosen for long-term instead of short-term expectations. The structural reforms should auger well for the mid-cap funds to give good returns. The markets are expected to be choppy before the elections, and investors should take the opportunity to buy on dips.

Investors, who are less aggressive and wanting the best of both worlds might consider investing in small and mid-cap mutual funds with a higher proportion of investment in mid-cap companies, which have market capitalisations between two billion dollar and $10 billion. Historically, these companies have offered more stability than small-cap companies. Yet they confer more growth potential than large-cap companies.

As many small and mid-cap mutual funds are opening doors to investors again like, l&T Emerging Businesses Fund and DSP Small Cap Fund, it is a good opportunity for aggressive investors to consider investing from now to December in good mid-cap funds using the systematic transfer plan route. However, the investment horizon must be for a minimum of five years. For investors with a one-time investment, this could stagger their investments over a period of one year, buying on downswings.

However, small and mid-cap funds are still overvalued. Hence, investors need to tread carefully and analyse the scheme’s track record across the market cycles and decide on the suitable mutual fund scheme, depending on how much diversification is necessary for the portfolio.

(The writer is Assistant Professor, Amity University)