Don't let exposure to mid and small-cap funds exceed 30%: Experts

They will outperform if GDP, earnings growth sustain, but global risks pose threat

Mid-cap and small-cap funds have outperformed large-cap funds during the bounce back from the June 2022 lows. While large-cap funds have yielded 7.1 per cent, mid-cap and small-cap funds have given returns of 11.4 per cent and 12.9 per cent, respectively, over the past three months ended October 10.        

One reason for this outperformance is the domestic orientation of mid- and small-cap segments. “Large-caps have larger exposure to information technology (IT), energy, commodities and financials. Mid- and small-caps have greater exposure to capital goods, chemicals, building materials, and consumer discretionary companies that are relatively smaller and cater to the domestic market,” says Shridatta Bhandwaldar, head of equities, Canara Robeco Asset Management Company (AMC).

Currently, global factors — high inflation and interest rates, Russia-Ukraine war, and China-Taiwan tensions — are weighing on market sentiment.  

“A slowdown in the developed world is likely to hit large-cap companies (IT, pharma, and so on), which derive their revenues from these markets,” says Niket Shah, senior vice president and fund manager, Motilal Oswal AMC.

Also, gross domestic product (GDP) growth is recovering from its pandemic lows. “During periods of good GDP growth, mid-caps tend to do better than large-caps,” says Shah.

Earnings growth has emerged from a long period of stagnation. Says Arun Kumar, head of research, Fundsindia.com, “There has been an uptick in earnings growth and it is expected to remain strong over the next three to five years.”

In such an environment, mid- and small-caps tend to grow at a faster pace than large-caps. Experts expect mid- and small-cap funds to do well so long as GDP and earnings growth remain strong.

Strong retail participation — these investors typically invest more in the mid- and small-cap segments — has also provided a fillip.

Expect volatility in near term

Globally, central banks are raising rates relentlessly to bring inflation under control. The Reserve Bank of India can’t let a large differential develop between interest rates in India and those in developed nations like the US. “The cost of capital is rising, both for Indian consumers and companies. Higher cost of capital could result in earnings downgrades for Indian companies. The markets could turn volatile,” says Kunal Valia, chief investment officer-listed investments, Waterfield Advisors.

According to Shah, a China-Taiwan flare up, which would affect supply chains, is another potential source of risk.  

Valuations within the mid- and small-cap space are not cheap. “They are not trading at a discount to large-caps,” says Valia.

Small-cap companies in particular face risks to their business. Goods and Services Tax and demonetisation have led to a large shift in market share from the unorganised to the organised sector. Not only have larger companies grabbed market share from smaller ones, they have also entered businesses where they were not present earlier.

Small-cap companies, which have lower pricing power, tend to see larger drawdowns wherever economic growth slows.  

What should you do?

Enter the mid- and small-cap categories now only if you fulfil a few conditions. “Have an investment horizon of at least three to five years. You must also have the appetite to stomach volatility, which tends to be higher in these segments than in large caps,” says Bhandwaldar.

Adopt an asset allocation approach. “Have a 70 per cent allocation to large-caps and about 30 per cent to mid- and small-cap funds. Of this 30 per cent, 20-30 per cent may be allocated to mid-cap funds and 0-10 per cent to small-cap funds,” says Valia. Mid- and small-cap exposure can be raised when valuations turn more attractive (if risk appetite permits).

When selecting a fund, opt for a consistent performer based on rolling returns. Select diversified portfolios to neutralise liquidity risk, which tends to be especially high in small-cap funds. Kumar suggests that once the fund size grows very large, investors should keep an eye to see if size is affecting performance or forcing the fund manager into any sort of compromise.