Avoid drastic shift away from large-cap, into mid-, small-cap funds

Stick to strategic allocation; keep tactical deviations within a narrow range

According to year-to-date data available up to the end of July, investor preference has swung away from large-cap funds and towards mid-cap and small-cap funds. Large-cap funds have witnessed outflows of Rs 3,258 crore, while mid-cap and small-cap funds have attracted Rs 11,932 crore and Rs 22,040 crore, respectively, according to data from the Association of Mutual Funds in India (Amfi).

Market experts recommend that investors avoid getting swayed by recent performance trends and instead focus on an allocation that aligns with their risk appetite.

Says S Naren, executive director & chief investment officer, ICICI Prudential Asset Management Company, “Investors are increasingly focusing on mid and small caps where valuations are costly and less on large-cap, multi-cap and flexi-cap strategies which appear to be relatively safer options in the current market conditions.”  

Driven by recency bias

A major driver for this pivot is recency bias. “The recent outperformance of mid and small-caps over large-caps is the key factor,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Adds Avinash Luthria, a Securities and Exchange Board of India or Sebi-registered investment advisor (RIA) and founder, Fiduciaries: “Mid- and small-cap funds have outperformed large-cap funds across time horizons. Investors find this very attractive. Mutual fund distributors, too, get a great sales narrative in this data.”  

The Amfi figures on outflows from large-cap funds are for active funds. In recent times, flows into the large-cap category have moved towards passive funds due to greater awareness that large-cap active funds are finding it hard to outperform their indices.  

Lure of mid- cap and small-cap funds

Many investors invest in these funds because they believe the long-term India growth story will be captured better by mid- and small-sized businesses rather than by large-caps. “This may not necessarily turn out to be true. Growth in various sectors may be captured by stocks belonging to various market caps, depending on the market segment the leader belongs to,” says Dhawan.

Many mid-cap and small-cap funds are smaller in size than their large-cap peers. Funds with smaller asset sizes can charge a higher expense ratio and hence pay higher commissions to distributors. “Distributors have an incentive to push these funds,” says Luthria.

Large caps could be safer

Experts say large-cap funds are a better bet at present. “In the large-cap space, we saw Rs 2 lakh crore of redemptions, predominantly by foreign institutional investors (FIIs). This removed the froth and increased the margin of safety in large-caps,” says Naren.

The small-cap space has not witnessed any redemption cycle since 2008. “Valuations of companies with strong fundamentals, and otherwise, have risen rapidly. This is the challenge of investing in small-caps at this point,” adds Naren.

Some fund managers have stopped lump-sum investments in their small-cap funds due to difficulties in deploying large sums at prevailing valuations.

Beware volatility

While mid-cap and small-cap funds have outperformed their large-cap peers, those returns have come with higher volatility. “In 2008-09, the Nifty Large-cap 100 total return index (TRI) fell 61 per cent, Nifty Midcap 150 TRI fell 73 per cent, and Nifty Smallcap 250 TRI fell 76 per cent. Similarly, in 2020, large-cap fell 38 per cent, mid-cap fell 38 per cent, and small-cap fell 43 per cent,” says Luthria.

Diversify across market caps

Investors should build their portfolios with a strategic mix of large-, mid-cap, and small-cap funds, depending on their risk profile. Dhawan suggests an investor -- with a moderate risk profile -- should have 70:20:10 allocation to large-cap, mid-cap, and small-cap funds, respectively; a conservative investor should have 90:10:0 allocation; and an aggressive investor go for a 50:30:20 allocation.

Luthria believes investors should stick to a Nifty 50 index fund in their equity portfolios. “Mid, small-cap and micro-cap stocks comprise around one-fifth of the market. If at all one invests in them, the allocation should not exceed 20 per cent of the equity portfolio,” he says.

Dhawan adds that any tactical deviation from one’s strategic allocation — on the basis of valuations or a forward-looking view — should be within a narrow range. “If you move out of large-cap funds and invest fully in mid-cap and small-cap funds, you would increase portfolio risk excessively,” he says.