Small and mid-cap funds maybe the ‘new’ flavour but here’s what you should know before investing

• Small-cap funds experienced an all-time high inflow of over ₹5,400 crore in June.
• Mid-cap funds registered a positive inflow of close to ₹1,750 crore in this period.
• Given that small and mid-cap funds invest in smaller size companies, they are more sensitive to market/economic changes.

The Indian stock markets have been volatile in recent times. From the continuous highs that the Nifty and Sensex were hitting after the start of the financial year, the last 10-odd days have seen volatility spike and the benchmarks down close to 1.5% in the past five trading sessions. In such a scenario, the question which arises is if it is prudent to invest in smallcap and midcap mutual funds which have been seeing an uptick in the bullrun.

According to data released by the Association of Mutual Funds in India (AMFI), inflows into equity-oriented schemes of mutual funds (MFs) reached a three-month high of ₹8,637.49 crore in June. This marked a significant increase compared to ₹3,240 crore in May and ₹6,480 crore in April. Notably, small-cap funds experienced an all-time high inflow of ₹5,471.75 crore, while mid-cap funds registered a positive inflow of ₹1,748.51 crore. Large-cap funds, on the other hand, saw an outflow of ₹2,049.61 crore during the same period.

“Looking back at the last 5 calendar years starting from 2018, while both the mid cap and small cap indices did extremely well in 2020 and 2021, their performance in 2018, 2019 and 2022 have been underwhelming. That said, both the indices have bounced back in 2023 and outperformed the large cap index,’ says Nehal Meshram, senior research analyst, Morningstar.

She says that despite global uncertainty, the Indian economy and markets have been resilient thereby creating a positive atmosphere, which is conducive for the mid and small cap segments to excel. Many portfolio managers, with their superior stock picking skills, were able to effectively capitalise on this opportunity, thus leading to the funds from these categories performing well. During a bull run and favourable environment, mid and small cap segments tend to perform better than their large cap counterparts, and that is exactly what we have witnessed this year so far.

We take a look at the returns of some small and mid-cap funds that have been in existence for at least 5-years, as compared to the benchmark.

Small-cap funds

Mid-cap funds

Source: Valueresearch, Return as on 31 July 2023

What you should know before investing in small and mid-cap funds

Small and mid-cap funds have historically shown high growth potential and can be excellent wealth creators. It is essential to recognise that investing in small and mid-cap funds also comes with increased volatility in the short term. Given that they invest in smaller size companies, they are more sensitive to changes in market conditions, economic factors, and company-specific events.

“As a result, the stock prices can experience larger price swings than larger, more stable companies. Therefore, investors must have a long-term investment horizon while investing in small and mid-cap funds,” says Meshram.

It is also important to understand that past performance or recent performance may not necessarily indicate similar outcomes in future. Hence, if one is tempted to put money in mid and/or small cap schemes of mutual funds just because of the recent bull run, it may be an inappropriate approach. Hear that risk and return go hand-in-hand.

“If one invests in a high-risk investment product and expects handsome returns in the short and/or medium term, he may be demoralised. Investing across market cap shall depend on investment objective, risk profile investment time horizon and prevailing market scenario,” says Arijit Sen, a SEBI-registered investment advisor, and co-founder of Merry Mind, a financial advisory firm.

Hence, it is important to evaluate your risk tolerance before investing in small-cap and mid-cap funds, as they tend to be more volatile than large-cap funds, leading to larger price fluctuations and market downturns.