Exit small, midcap funds if risk appetite low and time horizon short

Those having considerable amounts of both should rebalance and stay put

Over the past year, while the Nifty50 is up 27.4 per cent, the Nifty Midcap 150 has risen 56 per cent and the Nifty Smallcap 250 is up 65.9 per cent. 

Both mid and smallcap funds have witnessed heavy inflows over this period. After such a humongous run-up, investors need to turn extremely cautious in these segments.      

Risks higher in smallcap funds
 

The risks, say experts, are greater in smallcap funds than in midcap funds. “Smallcap schemes have larger exposure to stocks outside the top 500 stocks in terms of free-float market cap. These more volatile stocks have run up a lot in the recent past,” says Abhishek Kumar, a Securities & Exchange Board of India (Sebi)-registered investment advisor and founder, SahajMoney. Smallcap funds have lower exposure to largecap stocks. They also have lower cash positions that can support large redemption requests. 
 

Key risks

Valuation: Small and midcap stocks’ valuations have turned rich. “Historically, such run-ups have often been followed by a 

market correction or a time correction, as seen in 2017-18,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor.
 

Forward earnings multiples at the index level may not appear as exorbitant as in 2018. “But when you try to find quality companies at reasonable valuations, that is when the challenges begin,” says Roopali Prabhu, chief investment officer and co-head, products & solutions, Sanctum Wealth.

Liquidity: Liquidity risk could come to the fore if sentiment changes, especially for large-sized funds that hold a significant portion of the free float of a stock. A fund manager may be hit by large redemption requests, or his views on a stock may change, prompting an exit.
 

“The real risk is that of high impact cost. Fund managers may be forced to sell at a lower price, which could affect the fund’s future performance,” says Prabhu.  
 

Fund managers typically say they will be able to liquidate their positions through block or bulk deals. “Executing such deals is easier in a buoyant market, not when market buoyancy declines,” says Prabhu. Trading volumes of smallcap stocks tend to fall in bearish markets.

Information asymmetry: With so much money flowing in, fund managers face a dilemma: buy more of the existing portfolio stocks or add new ones. If liquidity in existing stocks doesn’t allow additional investment, managers are compelled to expand their portfolios. “This leads to a long tail of stocks. 
 

But it raises concerns about the fund manager’s ability to have an adequate grip (understanding) of the, say, 130th ranked stock in his portfolio,” says Prabhu.

Behavioural: Investor expectations have got pegged to recent returns. Many expect such returns to continue year after year. “Investors may over-allocate to small and midcap funds instead of diversifying across sub-asset and asset classes,” says Belapurkar.
 

First-mover advantage: When sentiment reverses significantly, as happened in 2018, many investors head for the exit. Fund houses sell whatever stocks they can to meet redemption requests. Inevitably, they end up selling the higher quality, more liquid stocks. What is left in the portfolio is lower quality and less liquid stocks. Long-term investors end up subsidising those who exit early. Market regulator Sebi is urging fund houses to develop a framework to protect long-term investors.
 

What you should you do
 

Have adequate allocation to fixed-income instruments, especially if you are nearing an important goal. “In case of a sudden downward movement in the small and midcap space, you should not have to redeem from these funds at a loss,” says Kumar. He also suggests having only that money in mid and smallcap funds that can stay invested for the next 5-10 years.

Those who cannot bear significant downturns (as much as 40 per cent) or have a short horizon should exit entirely. 
 

Those who have both should stick to their asset allocation. “If you have become overweight on these segments, rebalance your portfolio,” says Belapurkar. Avoid lump sum investments at this juncture and stick to systematic investment plans.