Explained: Small-cap, mid-cap and thematic funds steal the show in August

Equity-oriented funds continued to witness net inflows in August, making it the 30th consecutive month of net inflows. The segment witnessed net inflows of Rs 20,245.26 crore in August 2023,167 per cent higher than what it witnessed in the previous month (Rs 7,625.96 crore).

"Monthly flows into domestic equity mutual funds jumped by 167% in August, to a 5-month high of $$2.4bn. The rise in flows was supported by easing redemption pressure, as gross sales grew by 17%  month on month, while gross redemptions declined by 20%  month on month. Redemption pressure improved meaningfully in Largecap funds in August, but remains elevated relative to historical levels," noted Amorita Goel of Goldamn Sachs.

Thematic funds see the highest inflows, but should you invest?

Among the equity asset class, the sectoral/thematic funds saw the highest inflows to the tune of Rs 4,805.8 crore during the month. 

"The spike in the flows of this category could also be attributed to the fact that there were five new fund launches in this segment which cumulatively garnered Rs 2,556 crores during the month," said Melvyn Santarita, Analyst - Manager Research, Morningstar India.

These schemes — HDFC Transportation and Logistics Fund, HSBC Consumption Fund, Kotak Quant Fund, Nippon India Innovation Fund, and Quant Manufacturing Fund — together collected Rs 2,560 crore during the launch period.

Since thematic funds allow investors to capitalise on specific trends or sectors they believe they will perform well in the future. This may be appealing in markets where certain sectors are expected to outperform. 

"Investors who are ready to take moderate to higher risks can opt for thematic funds. You must be aware of the sector and theme where you are placing your investment bet. This investment option is mostly for those investors who can read trends and adjust their investments according to the growth prospects.  When a particular sector or theme is expected to have significant growth prospects, such as technology, renewable energy, or healthcare, thematic funds that focus on these areas tend to attract investor attention. For example, thematic funds that invest in clean energy or electric vehicles are expected to do well in the long term, as these sectors are likely to grow in the years to come," said Adhil Shetty, CEO of Bankbazaar.

Also, it is important to note that this category cumulatively houses 136 schemes and to that extent, the net inflows in this category can seem elevated compared to other categories, which have a smaller number of schemes.

However, thematic funds invest in fewer stocks within a sector. Therefore, there is a limited diversification. By investing in thematic funds, a retail investor signs up for a concentration risk.

"Such a risk is worth it only if the investor fully understands that particular industry and it's up and down cycles. Even after that, the investor needs to time the entry and exit into the fund, which is daunting. Often, when the market is rising, investors feel confident to take such bets, which happened in August 2023, and may even continue in September. 
 

Between 2012 and 2021, only 9 out of 87 thematic funds outperformed the Nifty 100. Just 6 of these managed to surpass the returns from the index on a risk-adjusted basis. Therefore, retail investors should avoid thematic funds to keep their portfolios simple. Even if they are extremely willing to bet on some sectors, the allocation should not be more than 10%," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

Sectoral/thematic funds saw strong inflows supported by new fund offerings (NFOs); Small and Midcap schemes continue to see the largest inflows while Largecap funds saw modest outflows: Goldman Sachs

Among equity funds, small-cap schemes remained the biggest attraction for investors

Small and Midcap schemes continue to see the largest inflows, receiving a third of the total net inflows in August, while large funds saw further, albeit modest, outflows. There continues to be a strong divergence of flows between Smallcap and Largecap mandates, although the gap has narrowed recently.

 Both the small-cap and the mid-cap as a category continue to garner robust inflows every month despite concerns regarding inflated valuations.  Small-caps witnessed inflows of Rs 4,264.8 crore and mid-caps Rs 2,512.3 crore.

" Given the concerns regarding inflated valuations and difficulty in finding good opportunities in this market, some fund houses have opted to restrict flows in their small-cap funds," said Santarita.

Both the midcap and the small-cap indexes have seen a sharp rally over the last year. Consequently, investors have also flocked to this category with ever-increasing flows. 

"Investors should note that while both the midcap and the small-cap categories have the potential to deliver good returns, these categories inherently are volatile with sharp drawdown risks. Therefore, investors should have a long-term time horizon while investing in these categories. Opting to invest in these categories via the SIP route is a good way by which investors can ride the volatility whilst dollar cost averaging over long periods," cautioned Santarita.

The flows into hybrid funds also gained momentum with arbitrage funds and multi-asset funds attracting the majority of these funds.

Hybrid funds saw a total inflow of Rs 17,081.68 crore in August, compared to Rs 12,420.74 crore in July. 

Point to note: All hybrid fund categories witnessed inflows in August. Recently, fund houses have been marketing hybrid funds as a tax-efficient option compared to investing separately in equity and debt schemes.

Arbitrage funds receive the highest inflow: Why is it the flavour of the month?

The arbitrage category is typically used by investors to park their short-term money. The category, during volatile markets, has the potential to garner a slightly higher return than the relatable fixed-income categories. Therefore, the quantum of both inflows as well as outflows is generally high during such periods. 

Arbitrage funds received the highest inflow of Rs 9,482.65 crore. However, the category received an inflow of Rs 10,074.87 crore in July.

Arbitrage funds leverage the mispricing in equity shares in the spot and futures markets by simultaneously buying and selling cash market shares in futures or derivatives markets to earn the differential gain. 

"In August 2023, arbitrage funds received a robust inflow due to a better tax treatment than fixed deposits. Since arbitrage funds are treated as equity funds, they offer a massive tax advantage for an investor in the highest tax bracket. For such an investor, FD returns are taxed at 30% vs only 15% tax on arbitrage funds if redeemed within one year (short term) and 10% tax after one year (long term). So, if an investor earns Rs 1 lakh annual interest on an FD, her tax liability will be Rs 30,000. Compared to this, the investor needs to pay Rs 15,000 as short-term capital gains for selling his profits from an arbitrage fund as only Rs 10,000 if she sells the units after one year. Since arbitrage funds have shallow risk, they are better than liquid funds for parking funds required in the near future," explained Kulkarni.

Who should invest in arbitrage funds?

"If we look at the historical data of the last 1-3 years, we can spot that some of the best-performing arbitrage funds have generated 7.5 to nearly 8 per cent returns. These are largely stable returns without exposing your portfolio to high-risk investments. Many risk-averse investors and senior citizens would like to have this fund to have stable returns. Whereas if you compare the other equity-linked schemes such as Mid-cap and Small-cap funds, they have provided on an average 12-15 per cent returns. The choice depends on your objectives and risk appetite. If you want options for capital protection, liquid or arbitrage funds can help. But if you seek growth, take higher risks," advised Adhil Shetty, founder of Bankbazaar.

Hence, if you are expecting fixed returns without too many risks, you can opt for arbitrage funds but avoid putting all your funds into just one fund category. Your investment should be designed to cater to your financial goals, and tax savings, and able to beat inflation to help you generate enough income to support your financial needs.

Gold-exchange traded funds in demand 

Gold exchange-traded funds also registered a spike in investor interest, with net inflows touching a 16-month high of Rs 1,028 crore. In terms of quantum, this was the highest net inflow the category has witnessed over the last 16 months. "

"With continued hikes in interest rates in the US, inflation still higher than expectations, and growth rate slowing down, the appeal of Gold as a safe haven and hedge against inflation is expected to continue. Moreover, Gold prices in recent times have come-off from its all-time high levels, thereby providing some buying opportunity, particularly after a sharp rally it witnessed since March this year," said Santarita.

Focused funds, large-cap funds and ELSS funds continue to see outflows in the equity space

The only categories which saw net outflows were Focused (Rs 471.1 crore), Largecap (Rs 348.9 crore) and ELSS (Rs 26.6 crore) funds. 

This was the fourth consecutive month where the large-cap witnessed net outflows and the fifth consecutive month the focused category witnessed net outflows. 

"Active large-cap funds have been finding it increasingly difficult to beat passive funds and therefore some investors could be choosing to exit active funds in this category and choosing the passive route. Passive funds as a category (Index and ETFs) continue to see healthy net inflows every month," said Santarita.

Other highlights

The total assets under management (AUM) in August 2023 increased by merely 0.56% in August, compared to July 2023.

Overall AUM of domestic equity mutual funds stands at $220bn, growing at a the robust pace of 22% annually in the last 4 years

"Looking across market-cap mandates, we note that the AUM share of Small and Midcap funds has been increasing at the expense of Largecap funds: in the last 4 years, Small & Midcap funds’ share of the overall equity mutual funds’ AUM has risen from 16% to 23%, while Largecap funds’ share has dipped from 19% to 14%," said Sunil Koul of Goldman Sachs.

Monthly inflows via Systematic Investment Plans (SIPs) remain strong and hit fresh highs at $1.9 billion (+4% m/m), supported by growth in SIP accounts, which has picked up pace since the second quarter of this year. SIP accounts grew 2.5% month on month in August, hitting fresh highs of 70 million accounts.

Overall cash level for the top 200 active equity mutual funds stands at 4.2% of AUM (US$6.7bn), near the long-term average of 4.1%. 

"Across mandates, we note that Small and Midcap mandates hold high cash levels at 5-7% of AUM, while Largecap schemes have 3-4% cash allocations. We think domestic equity funds, sitting on high cash levels, could continue to support markets in the near term," said Goldman Sachs.

Should you follow the herd?

Recently, the small and midcap funds have touched unprecedented highs. So, there is apparent interest from retail investors.

"If an investor had taken a tactical position in small and medium cap funds, keeping in mind a short-mid time target, it is an excellent time to book profits, as there are no fundamental reasons to support the momentum. However, someone looking to build long-term wealth should stick to the overall asset allocation, instead of chasing any momentum," said Kulkarni.

For example, if a long-term investor had a 10% small-cap allocation in his portfolio and the allocation has reached 20% due to the recent rally, she can rebalance her portfolio. To do this, she needs to partially sell the small-caps and reinvest the proceeds into other asset classes that were short of allocation targets."