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Market regulator Securities and Exchange Board of India's (SEBI's) focus on curbing excessive valuations in small-cap schemes is finally impacting investor sentiment. For the first time since August 2021, monthly inflows into small-cap schemes witnessed a reversal, with a small net redemption of Rs 94 crore in March 2024. This comes after a sustained period of strong inflows averaging around Rs 3,300 crore per month for the past 15 months, noted brokerage Elara Capital in a report.
Last month, a number of mutual fund companies made public the results of a 'stress test' that Sebi asked them to conduct on their small and mid-cap funds. The test is designed to tell us in how many days would a fund be able to liquidate 25 per cent and 50 per cent of its portfolio. As per Sebi's mandate, asset management companies (AMCs) are required to disclose the results of stress tests, along with metrics related to liquidity, volatility, valuation, and portfolio turnover, specifically for mid-cap and small-cap equity schemes on the 15th of every month.
Mid- and small-cap stocks had a stellar 2023, attracting significant investor interest to the tune of around Rs 64,000 crore. The markets regulator was concerned whether these funds could sell stocks when they wanted to and without incurring significant losses.
The decline in small-cap inflows seems to be accompanied by a rise in investor interest towards large-cap schemes. Large-cap funds witnessed a net inflow of Rs 2,130 crore in March 2024, marking the highest inflow in 21 months. This is a significant turnaround compared to the average monthly outflow of Rs 115 crore observed previously. Interestingly, nearly 70% of the inflows that previously went into small-cap schemes appear to have shifted towards large caps in March 2024.
There has also been a growing interest in Exchange Traded Funds (ETFs). ETF inflows reached a new high of Rs 10,500 crore in March 2024, compared to the average monthly inflow of Rs 2,500 crore. This trend aligns with the already observed increase in flows towards large and mid-cap schemes since February 2024.
While overall mutual fund liquidity remains healthy, a clear shift in investor preferences is evident. The focus seems to be moving away from small and mid-cap funds towards large-cap oriented options, including ETFs and index funds. A large portion of the outflows from small and mid-cap schemes came from just four AMCs, but this was partially offset by strong inflows into one AMC and smaller inflows into three others.
"Overall MF liquidity is still buoyant but shift has begun from Small/Mid into Large cap oriented funds (including ETFs/Index funds). Big shifting by investors within AMCs was also visible. Bulk of Small & Mid cap outflows were from 4 AMCs which was cushioned with strong inflow into 1 AMC and smaller into 3 other AMCs," said the report.
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Small cap flows were in strong uptrend since 2021. This is the first time since 2018, there has been a a strong reversal in Small cap flows (as a % of free float market cap).
Performance Matrix Weakens for Small Caps:
The report highlights a potential link between the flow trends and performance. The relative median returns of small-cap schemes compared to mid-cap schemes have been declining, potentially reflecting a loss of investor risk appetite for small and mid-cap (SMID) stocks.
Large cap flows (as a % of Free Float MCAP) started turning weak since October 22 and remained in strong downtrend since then. Finally some improvement visible.
Midcap flow momentum (as a % of Free Float MCAP) was flat since the past 18-months. Very early signs of reversal in that trend.
Small Cap Folios Lose Ground: For the first time since February 2021, the number of new accounts opened for small-cap funds (small-cap folios) has declined, indicating a decrease in investor interest.
Large Cap Folios See Surge: Conversely, there's been a sharp increase in new large-cap folios in March 2024. This is the biggest monthly rise since December 2021, highlighting a clear shift in investor preference towards large caps.
Mid-Cap Folios Show Moderate Decline: New mid-cap folio additions have also been dropping for the past two months, but the decrease is more moderate compared to small caps. This suggests a potential wait-and-watch approach for mid-cap investments.
Key takeaways:
The March sell-off presented an opportunity for some small-cap fund managers. They used this period to deploy their cash reserves for investments.
Cash levels in small-cap schemes dropped to 6.1% in March 2024 from 6.6% in February 2024. This indicates active deployment of cash holdings.
Interestingly, small-cap fund managers have been steadily increasing their holdings of large-cap stocks. This percentage reached a new multi-year high of 7.5% in March 2024. This strategy suggests a potential attempt by small-cap fund managers to hedge against risks.
