Small- and mid-cap meltdown: Difficult times call for a review of strategy

HNI investors experiencing pain in mid- and small-cap oriented PMS and AIF schemes need to review their funds, portfolios, and investment strategies

After a great run that lasted for four years (see table), mid- and small-cap stocks have witnessed a downturn in recent months. While the BSE Mid-cap Index is down 14.82 per cent year-to-date (YTD), the BSE Small-cap Index is down 17.76 per cent. Like retail investors in mutual funds, high net worth individuals, who have invested in Portfolio Management Services (PMS) and Alternative Investment Funds (AIFs), are also experiencing a lot of pain. To cite just one example, the return of Porinju Veliyath's Equity Intelligence PMS, which has given investors a compounded annual return of 31.33 per cent over the past 15 years, fell 18.59 per cent during the first quarter of the current financial year.  

Wrong set of expectations: At the end of 2017, the returns of mid- and small-cap focused schemes looked very attractive. A lot of the selling of PMS products happened on the basis of past returns. Investors were often led to believe that these returns would  continue in the future as well. "Many PMS managers spoke of generating returns of 30-50 per cent, which is clearly impossible over the long run," says Malhar Majumder, partner, Positive Vibes Consulting and Advisory. Investors who entered these schemes based on such promises are obviously a disappointed, even fearful, lot today.   

Entry at high levels: Investors who entered mid- and small-cap focused PMS and AIF schemes over the past one year, when valuations within this segment had already touched astronomical levels, have in particular borne the brunt of the fall. "Timing of entry definitely has a bearing on the returns of PMS and AIF schemes. In case of mutual funds, the systematic investment plan (SIP) route allows you to average out your cost of purchase. In case of PMS and AIFs, the amount invested in each tranche is quite large, so averaging out becomes more difficult," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisory. He adds that wrong timing will adversely impact returns in these schemes, at least in the short term.

Portfolios stuffed with similar schemes: Another mistake investors typically commit during bull runs is to fill their portfolios with similar products. "When investors select products based on past returns, they pick the two or three schemes showing the highest returns. In the recent past, that would  have meant that all the schemes they picked would  have been mid- and small-cap oriented. The PMS/AIF scheme, mutual funds, and even their direct equity investments would all have been made in the mid- and small-cap segment," says Dhawan. The correction, when it came, hit portfolios that were not properly diversified particularly hard.           

The way out

Stick it out: For most investors, financial advisors suggest that they should not react to the situation and instead just ride out this period of volatility. "You would  have entered these scheme with a 5-10 year investment horizon, so stick to it. In the long run, many of them do have the potential to beat the indices," says Anil Rego, chief executive officer, Right Horizons. 

Run a few checks: The current setback should, however, prompt a review of your strategy, fund and portfolio. First, check whether you have the risk appetite for an allocation  to mid- and small-cap funds. If the current bout of volatility has made you realise that you have a much lower level of appetite for volatility than you had previously imagined, then reduce your allocation  to the mid- and small-cap segment. Broadly, depending on your risk appetite, you should have a 60-70 per cent allocation  to large caps, 20-30 per cent to mid caps, and 10-20 per cent to small caps.    

If a review reveals that your portfolio is too heavily concentrated on the mid- and small-cap segment, reduce allocation to this segment to a level that your financial advisor thinks is suitable for your risk profile, and allocate more to the large-cap segment.      

Also, scrutinise the performance of your fund. "The scheme you have invested in should have declined in sync with its benchmark. If the fall was steeper, that would  call for a close scrutiny of the fund," says Vivek Banka, founder, Alitore Capital. In fact, times like these are a good test of the quality of schemes.

"It is in trying times like these that the quality of the underlying portfolio comes to the fore. In the mid- and small-cap segment also, there are companies that are market leaders, have strong balance sheets, low debt-to-equity ratios, and high free cash flows. Those stocks, and hence the schemes that invested in them, have suffered less," says Ajay Bodke, CEO and chief portfolio manager, PMS, Prabhudas Lilladher. 

Check if your fund manager stuck to quality stocks or got swayed by momentum and bet even on those having poor fundamentals. "If your fund manager has a sound long-term track record, that too should give you the confidence to stick to the fund," says Majumder. 

If you do decide to exit a scheme, be mindful of exit loads and tax impact. Many AIFs have closed-end structures. In case of PMS, different stocks may have been purchased at different points of time, so assessing whether they qualify for long- or short-term capital gain may prove complicated. 

Be mindful of the positives of PMS and AIF schemes before you decide to quit in a huff. "PMS scheme allow investors to speak to the fund manager. Take advantage of this facility. If his explanation appears logical and convincing, stick to the fund," says Dhawan. You also have much less to worry about if you are in a scheme where the fee is not flat but  depends on profit sharing. "This alignment of interest means that you are better protected in such scheme than where the scheme charges a flat fee irrespective of performance," says Ankur Kapur, founder, Ankur Kapur Financial Advisory Services.                   

Finally, bear in mind the concept of reversion to mean. "After their fantastic run since 2014, this correction was par for the course. But if you stick to these funds, their performance will turn around in due course," says Banka.