Should mutual fund investors trust small caps’ grit to keep momentum intact?

Investors have poured money into them not just directly but passively through mutual funds. As a matter of fact, these stocks have still not run out of steam and one can invest in them by being selective, observe experts.

Small Is Big
After an underperformance of the first quarter where Nifty50 fell 4.5% or 850 points, there has been no looking back by the benchmark indices and with them, the broader markets. Small and medium cap stocks kept the April and May momentum intact in June as well. The Nifty MidCap 100 gained 2,119 points or 6.3% in June while Nifty SmallCap 100 was up by 775 points or 7.7%.

Riding on the euphoria, mutual fund investors betted mostly on the small cap funds, followed by the medium cap funds. Between April and June, inflows worth Rs 10,937 crore were witnessed in small cap mutual funds with month-on-month rise. Nearly half of it (Rs 5,471.75 crore) came in June.

In mid caps, the inflows during the quarter stood at Rs 4,735.14 crore and as for the large cap mutual funds, there were outflows worth Rs 3,359.26 crore in the three months ended June 30.

Risk Appetite
On why there is a heightened rush towards the small cap stocks, Nitin Rao, Head of Products and Proposition at Epsilon Money Mart said, “We can attribute this to two reasons — one is smallcap index has been consolidating since a long time and secondly, investors are showing the willingness to shift their investments towards riskier assets.” By investors, he means people looking to invest in equity markets with at least 3 years’ horizon and at least 7 years for small cap investments.Echoing a similar view, Alekh Yadav, Head of Investment Products, Sanctum Wealth, said by December 2021 small cap valuations had become stretched after a stellar rally through the year, which led to significant underperformance by small caps in the first half of 2022, in comparison to the large cap stocks.

Once the valuations got rationalised by the end of the first quarter in 2023, smallcaps picked-up significantly, outperforming the large caps, Yadav reiterated.

Going Ahead
As a result of the euphoria, several asset management companies (AMCs) have stopped lumpsum investments in their smallcap schemes, Rao informed. He is of the view that while some froth is emerging now, the Street doesn’t expect a drop like Covid-19 scenario. “Therefore, if long term goals are in place with proper risk analysis investors can continue to invest,” he opined.

On valuation front, Yadav of Sanctum Wealth believes they are not stretched currently as was the case in December 2021, though “they aren’t cheap either”. “The recent rally for smallcaps has been very steep and hence we believe there is scope for a breather. We are neutral smallcaps and hence suggest investors should limit their small cap exposure to their strategic allocation weights. Those overweight smallcaps could look to book some profits,” he advised investors.

Yadav’s advice to investors is to use systematic investment plans (SIPs) and stagger investments instead of going the lump sum route. Any correction in markets should be used as an opportunity to add to equities, he said.

Rao, too, remains a firm believer of SIPs and recommends continuation in investments despite market making highs. “The beauty of SIP is in not timing the markets and effortlessly reaching our goals. Therefore, if your risk appetite and time horizon matches your profile, you can continue to do so,” the Epsilon Money Mart expert said.

Laggard Large Caps
Small cap mutual funds along with gold and gold ETFs have given substantially higher returns versus the large cap funds, said Aayush Agrawal, Senior Research Analyst at Swastika Investmart, attributing very low returns to the exodus of money from the large cap mutual funds. “People may withdraw money from large-cap funds for a variety of reasons. If we look at the data from the past two years, we can see that the large cap fund has not been performing well, and as a result, investors are not satisfied with the returns,” he said.

Unlike small caps, which offer a substantially larger investing universe, large cap funds do not offer as vivid options as the former, which restricts fund managers’ ability to optimise returns, Agrawal added. “Regular monitoring of sectoral index performance and switching portfolio allocation as per economic trends will generate higher returns for investors,” he said, further.

Rao of Epsilon recommends investment in large cap funds for largely those investors who are first timers or new to equity investments. The large cap companies are still to come out of their consolidation phase and need to catch-up, he reasoned.

Dancing with Debt
May was the worst month for the overall equity mutual fund schemes with inflows of just Rs 3,240 crore as investors preferred debt schemes over equity. In April and May, inflows worth Rs 1.5 lakh crore were received in various debt fund schemes with the lion’s share going into liquid funds.

The turnaround for debt-oriented mutual funds after a March debacle could be attributed to corporations likely storing extra investable funds in the liquid fund and ultrashort term fund categories, temporarily, after paying their tax obligations, Agrawal points out.

However June saw outflows of Rs 14,135 crore in the debt mutual funds. The Swastika Investmart analyst sees the impact on account of new tax rules, where investments in debt mutual funds that are bought on or after April 1, will be taxed as short-term capital gains at applicable tax rates. This means that capital gains from debt, international and gold exchange-traded funds, irrespective of their holding period, will be taxed at an individual’s relevant applicable tax rate, he added.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)