Mid-cap and Small-cap Funds: How can retail investors get the best out of them?

Small and midcap funds have become investors’ favourites in the past three years. As per the Association of Mutual Funds of India (AMFI), the mutual fund industry’s trade body, the number of investor accounts in midcap funds more than doubled to 1.4 crore in the last four years, while smallcap funds' folios more than tripled to 1.9 crore. But small and midcap funds are different from largecap funds in terms of their risk, return and diversification. Here’s what investing in these small and mid- cap funds entails.
Data source: ACEMF and Niftyindices.com.

Midcap mutual fund schemes invest at least 65 percent of their assets in the mid-sized companies that are ranked between 101 and 250 based on their full market capitalisation while smallcap schemes invest at least 65 percent in the small companies that are ranked beyond 250 in terms of full market capitalisation.
Nirav Karkera, Head of Research, Fisdom, says, “Mid and smallcap companies often have higher growth potential because they are in their growth phase. These stocks are less tracked by analysts compared to largecap stocks. This can result in market inefficiencies and undervaluation, providing opportunities for active fund managers to uncover hidden gems and generate alpha for investors”.

Also see: Top 10 stocks that power MC30 equity schemes

Volatility is the middle name of mid and smallcap funds
Mid and smallcap stocks react faster to the changing market environments. Despite potential short-term volatility, these funds often offer significant returns over extended periods, primarily fuelled by the growth potential of smaller companies.

Tip: Small investors should approach mid and smallcap funds with a strategic mindset that combines a long-term investment horizon with a thorough assessment of their risk tolerance, adds Karkera.

Despite higher growth potential, small and midcap companies are more sensitive to market changes.
“Understanding and preparing for such fluctuations, whether during bullish or bearish market phases, is essential for small investors to make informed decisions when considering mid and small-cap funds”, advises Karkera.

Smallcap funds can undergo prolonged underperformance
Small investors who want to invest in smallcap funds should have the fortitude to handle market volatility. It is highly probable that smallcap funds will produce zero or negative returns for a prolonged period of three to four years.

Also see: Worried about market volatility? Check out these MC30 schemes that provide stability and high growth

To reduce risks, small-cap funds are diversified
A growing corpus can slow a fund’s performance. It can also make the fund risky if it holds a concentrated portfolio. One of the ways in which fund managers counter this issue is by increasing the number of stocks in the portfolio.
Many funds in the small and midcap categories increased the number of holdings in their portfolio. The largest fund in the category, Nippon India SmallCap Fund (Rs 45,749 crore), has 199 stocks in its portfolio and is well-known for its impressive track record.


The flipside of holding an over-diversified portfolio:
One of the disadvantages of holding too many stocks in the portfolio is that the portfolio can become a very ordinary portfolio that will find it difficult to beat the benchmark.

Risk of stopping inflows
Smallcap is one category where liquidity is poor and impact costs are high compared to largecaps and midcaps. Therefore, the extra gush of inflows has forced some mutual funds to curtail fresh investment into these schemes. About five smallcap funds with larger asset size have stopped accepting fresh subscriptions. It is mainly due to limited opportunities in the smallcap space due to the sharp run-up in stock prices. Funds that stopped/capped fresh subscriptions either through lump sum or the systematic route include Nippon India Smallcap, Tata Smallcap, SBI Smallcap, Kotak Smallcap and ICICI Prudential Smallcap fund.

Is it a right time to start investing in mid and small-cap funds?

Smallcaps can be volatile on both sides of the market, in a bull run and in a correction. It is very important that investors coming into smallcaps have a long-term view and have a risk profile to withstand the volatility.
Karkera of Fisdom says that valuations seem stretched in some pockets. But smallcap and midcap segments continue to offer some pretty robust growth stories. The risk-reward seems slightly better for most of the midcap stocks. The best way to invest in small and midcap funds is through systematic investment plans.
Investors can consider investing in the midcap and small-cap funds that are part of the MC30 basket.

Let’s meet the MC30 midcap and smallcap funds

Also see: The sparkling list of MC30

Edelweiss Mid Cap Fund
Category: Mid Cap Fund
Fund Managers: Trideep Bhattacharya and Sahil Shah
Average 7-year return (CAGR): 16.7%

PGIM India Midcap Opportunities Fund
Category: Mid Cap Fund
Fund Managers: Anandha Padmanabhan Anjeneyan, Utsav Mehta, Vinay Paharia and Puneet Pal
Average 7-year return (CAGR): 16.7%

Also see: First-time equity investor? Limit your risks with large-cap funds from MC30

SBI Magnum Midcap Fund
Category: Mid Cap Fund
Fund Manager: Bhavin Vithlani
Average 7-year return (CAGR): 14.6%

Nippon India Small Cap Fund
Category: Small Cap Fund
Fund Manager: Samir Rachh
Average 7-year return (CAGR): 21%

Also see: Top mutual funds: 3 new schemes that enter Moneycontrol’s sparkling list of investment-worthy funds; MC30

SBI Small Cap Fund
Category: Small Cap Fund
Fund Manager: Mohan Lal and Rama Iyer Srinivasan
Average 7-year return (CAGR): 20.8%

Also see: SIPs in MC30 top mutual funds deliver consistent returns