Have an exit strategy for mid- and small-cap funds

The BSE Sensitive Index, or Sensex, is hovering around 31,000 points and grabbing all the headlines. But, the real action is taking place in mid- and small-cap indices. Both these have hit several all-time highs in the recent months. The average daily turnover of stocks in the BSE Midcap and BSE Smallcap indices in FY18 so far has been Rs 637.5 crore and Rs 1,574 crore, respectively. In comparison, daily average turnover of Sensex stocks has been Rs 676.3 crore. In volume terms, the daily average of shares traded in Sensex was 12 million in FY18 so far vs 32 million in the BSE Midcap and 146.3 million in BSE Smallcap index stocks.    

“When the market is going up consistently, sooner than later, both fund managers and investors start running out of ideas. Then, they start chasing mid- and small-cap companies aggressively, as it brings more diversity to their portfolio,” says a fund manager who manages over Rs 10,000 crore of equities.

So where do you stand as an investor? While the basics of evaluating any mutual fund (MF), remain the same for all schemes, investors need to go the extra mile when selecting a mid-cap or small-cap fund. A scheme in these categories can underperform for months and then, give returns in spurts, putting it in top performers’ league after the long lag. Investors, therefore, need to look beyond rolling returns, risk-reward ratio, expense ratio, third-party ratings, and other standard parameters of assessing MFs.

If you have invested in any of the five best performing mid- or small-cap schemes between 2011 and 2013, only one (Franklin India Smaller Companies Fund) among those remained at the top in 2016.

Mid- and small-cap schemes are more dependent on the bets a fund manager places. There’s plenty of information available on large-cap companies. But, fund managers of mid- and small-caps need to discover stocks that have not caught the fancy of other investors and have the potential to be multi-baggers in the future. “When these bets play out, the scheme returns start heading north,” says Nishant Agarwal, head of products, investment advisory and family office, ASK Wealth Advisors. 

Look deeper in the portfolio: Analyse the portfolio in depth to understand the volatility a fund can experience. The higher the percentage of mid- and small-cap companies, the more volatile it can get. Also, look at the concentration of the portfolio in top 10 and top 15 stocks. 

There could be completely different styles of managing such funds. A quick look at the portfolios of two top performers among mid-cap funds, according to Value Research data, presents an interesting picture. 

Mirae Asset Bluechip Fund, which has returned 40 per cent in the past year, has Federal Bank, Kotak Mahindra Bank, Ceat, IndusInd Bank and ICICI Bank as its top five holdings — around 18 per cent of the portfolio. LIC MF’s Mid-cap Fund, which had given similar returns, has UPL, Indian Oil Corporation, Tata Chemicals, Motherson Sumi Systems and Britannia as its top five holding, which is around 22 per cent of the portfolio. Clearly, one fund manager believes in private sector banks and the other in more variety.  

Fund manager’s skills paramount: Increasingly, fund houses are becoming process-oriented. It means they rely more on research and data for investments. But, when it comes to small- and mid-cap funds, the call of the fund manager matters more, as there’s limited research and data on companies with smaller market capitalisation. The decision to buy a mid- or small-cap stock rests more on its promoters than on financial parameters.

Describing his stock picking process, Vinit Sambre, senior vice president, DSP BlackRock Investment Managers, says he puts his conviction on the management of the company, after meeting them and understanding their views on the business. The passion a promoter has for his business cannot be captured in numbers. “As most smaller companies are promoter-driven, it is necessary to clearly understand how promoters think,” says Sambre.

Should you exit a scheme of the fund manager if he leaves? “As stock picking largely depends on a fund manager’s ability in mid- and small-cap stocks, in most cases we suggest investors redeem if the manager quits or changes,” says Agarwal of ASK Wealth Advisors.

Liquidity issues: While mid- and small-cap stocks have the potential to deliver higher returns (compared to large-caps), they have lower free float and investors can face liquidity issues when selling these. If a fund invests six per cent of a Rs 5,000-crore portfolio in a mid- or small-cap stock, that would be Rs 300 crore. With such holdings, it can get difficult for a fund manager to exit the stock.

During good times, these schemes are quick to impress, however, they are also the first ones to take a hit when there is uncertainty

“As the AUM of a fund grows, managers need to diversify more to avoid such liquidity issues,” says Sambre. His DSP BlackRock Micro Cap Fund started diversifying by adding more stocks when it reached assets of around Rs 3,500 crore. At Rs 5,818 crore, the fund holds 82 stocks. In comparison, SBI Small & Midcap Fund has assets of Rs 691 crore and holds 27 stocks. 

Have an exit strategy: In the current market, there’s a high interest in mid- and small-cap companies. If there’s a correction, these are going to be hit the hardest, as valuations of many stocks are stretched. This can directly impact your fund. It is, therefore, important that you have an exit strategy in place.

You can book profits in these funds instead of large-caps when rebalancing your asset allocation. Also, watch for portfolio churn. Mid- and small-cap funds shouldn’t have high churn, as the investments made are for the long term. High portfolio churn would mean the fund manager is either chasing short-term profits or doesn’t have conviction on his bets.

If a scheme has been a consistent performer in the past and you trust the manager, stick with it. “A fund manager in this category endeavours to get stocks before it catches the attention of other investors. Investments take three to five years for results as the company grows bigger in size. Investors, therefore need to be more patient in small- and mid-cap funds,” says Sailesh Raj Bhan, deputy CIO, Reliance Mutual Fund.