Journey of midcap, smallcap schemes: 6 years from the previous peak

Smallcap and midcap scheme categories have raked in over Rs 60,000 crore of investor flows in the past one year

Smallcap and midcap funds are in the spotlight. There are heated arguments on whether they have peaked or there is more steam left in them.

Are they attracting more than their fair share of inflows? Will they be able to meet the redemption requests in case of a sudden fall in markets?
 

We analyse their performance in 2018 — when markets regulator Securities and Exchange Board of India (Sebi) first introduced the categorisation norms.
 

We will also study the latest stress test results to gauge whether these questions really matter for investors who remain invested for long and how is the industry poised.
 

Smallcap and midcap schemes have raked in over Rs 60,000 crore of investor flows in the past one year.
 

They accounted for over 34 per cent of the total net inflows into actively-managed equity schemes.

 

The flows into these schemes have accelerated after a relentless up move in the shares of small and midcaps since the bottoming out in the markets in March 2023.
 

Between April 2023 and February 2024, the Nifty Smallcap 100 index rallied over 80 per cent, while the Nifty Midcap 100 index soared more than 60 per cent.

They have given up some of the gains in recent weeks but their return scorecard is still impressive.
 

The decline in recent weeks comes amid sounding of caution from the stock market watchdog, which feels there is a build-up of forth. And, measures are needed to ensure that the bubble doesn’t get too big.
 

Going by the valuations, analysts see little scope for further price-to-earnings (P/E) expansion.
 

They feel that the current P/E levels are justified only if companies are able to deliver high earnings growth.
 

The 12-month trailing P/E of Nifty Smallcap 100 and Nifty Midcap 100 are close to 28x and 37x, respectively. In comparison, the Nifty 50 and Sensex are trading at 23x.
 

Barring the sharp rebound in the markets after the Covid-19 slump, the last time smallcap and midcap indices had rallied this sharply was during 2016-2017. From a low of 4,354 in February 2016, the Nifty Smallcap 100 index more than doubled to 9,093 by December 2017. A similar rally was seen in midcap indices during the same period.
 

The smallcap and midcap stocks corrected soon after and had to ensure a prolonged period of inaction.
 

The smallcap indices took nearly three and a half years to come back to the same levels and the midcap indices, too, took nearly three years to recover lost ground.
 

As the discussion around an impending correction in smallcap and midcap stocks grows louder, we take a look at the performance of midcap and smallcap funds during the previous bear phase and their returns till date (from January 2018).

The idea is to see if investors who invested at the peak of the previous cycle made money and if staying put for the long term makes the entry point less of a factor.
 

While past performance cannot be a guarantee for future returns, fund managers have been able to ride the storm well in the past, shows data.
 

To illustrate: The Quant Small Cap Fund has gone up 3.4x since June 2018, delivering an annualised return of 27 per cent. Even during the bear market phase between January 2018 and June 2021, it delivered gains of 125 per cent even as the Nifty Smallcap 100 total return index (TRI) went up by just 11 per cent.
 

Interestingly, during the Covid fall in March 2020, most schemes managed to cushion the slide.

In smallcaps, fund managers find elbow room to outplay markets

The analysis of past six years’ performance of smallcap funds shows that active funds don’t hug their benchmark as closely as their largecap peers.
 

All the 13 schemes, which were launched before 2018 and have over Rs 1,000 crore assets under management (AUM), managed to beat the Nifty Smallcap 100 index in terms of performance during the three and a half years (January 1, 2018-June 30, 2021), the recovery period after the 2018 peak. Also, eight of these schemes delivered double-digit returns on an annualised basis even as the index rose about 3 per cent (annual).
 

The divergence in performance shows that while the fund return is linked to market performance, fund managers have the room to deliver outsized returns. This is given the large universe of investable stocks.
 

The active schemes were also capable of preventing the downside, going by their performance during the Covid-19 market crash.
 

All the schemes fell at least 5 percentage points lower than the index, with two of them managing to beat the index by 11 percentage points. The downside protection figures are a comparison of Nifty Smallcap 100 TRI (Total Return Index) fall with that of each scheme.

Greater variance in midcap showing

A larger set of midcap funds have been operational since 2018, resulting in a wide variance performance in the last six years.

Their performance during the three-year phase of recovery from the previous peak (January 1, 2018, to January 31, 2021), ranged from 14 per cent compound annual growth rate (CAGR) to -1 per cent CAGR.
 

Nine schemes were able to deliver fixed income-like returns even as their benchmark indices changed little. Interestingly, some of the schemes were able to bounce back strongly in the post-2021 period after underperforming significantly during the first phase.
 

Motilal Oswal Midcap Fund and HDFC Midcap Opportunities Fund delivered 19 per cent and 17 per cent CAGR since January 2018 even after a three-year period of just 3 per cent return.
 

Like the active smallcap funds, midcap schemes were also able to offer some downside protection during the Covid-19 downturn. We also look at the Sharpe ratio, which measures the performance of mutual fund schemes vis-a-vis the risk-free rate of return. The higher the Sharpe ratio, the better the fund’s historical risk-adjusted-performance.

Stress test: Smallcaps may face liquidity heat,midcaps better placed

While smallcap and midcap funds can deliver outsized returns during bull phases, investors often tend to pay little attention to the aspect of ‘liquidity’ when it comes to investing in this space.
 

Liquidity, in other words, is whether a fund will be able to easily liquidate its holdings in case there is a sharp downturn in the market.
 

Often, the trading volumes in smaller companies tend to be small. Additionally, most counters have narrow circuit filters, which make it challenging for a fund manager to sell an adequate quantity of shares if there is downward pressure on the stock.
 

Considering this risk, the Securities and Exchange Board of India (Sebi) has asked fund houses to ‘stress test’ their portfolios.

The first set of reports was released by fund houses this month.
 

The tests show that smallcap schemes with a large corpus may come under stress if there is a sudden surge in redemptions.

Stress tests showed that most of the  top 10 schemes will require more than 10 days to liquidate a fourth of their portfolio.

On the positive side, most smallcap schemes seemed well-placed to meet redemptions amounting to nearly 15 per cent of their portfolio, thanks to the high cash holdings and significant largecap exposure.
 

In the case of midcap schemes, the liquidity stress was relatively lower.  On an average, the top 15 midcap schemes had 15 per cent in cash and largecap stocks compared to 12 per cent in smallcap funds. The average number of days to liquidate 25 per cent of the portfolio (for midcaps) is also lower at 5.7 days against 11.6 days needed by smallcap funds. The stress test is based on recent trading volumes in underlying stocks.

The format also sets other specific conditions such as adopting a pro-rata basis of liquidation after removing the 20 per cent least liquid holdings. For the test, MFs have to assume a 10 per cent participation volume and three times the average daily volumes seen in the past three months for each of the stocks in the portfolio. MF schemes will have to periodically make the stress test disclosure.
 

While the jury is still out on whether these tests will be accurate in real market situations, they will definitely give both unitholders and fund managers a lot of food for thought.