Rising Investments in Mid and Small-Cap Funds: A Cause for Worry

The steady surge of investments into mid- and small-cap mutual funds has brought about worries regarding stress levels in these schemes. Small-cap funds witnessed a 24 per cent increase in depositors last month, amounting to ?6,484 crore, compared to ?4,024 crore the previous month. Simultaneously, inflows into mid-caps rose by 38 per cent, reaching ?5,182 crore, up from ?3,754 crore during the same timeframe. This continual inflow has not only extended the time required to divest 50 per cent of the scheme portfolio but also heightened the related concentration risks.

As a case in point, HDFC Mutual Fund disclosed that liquidating half of its small-cap portfolio would take 54 days in July compared to 52 days in June. The small-cap Assets Under Management (AUM) of the mutual fund increased by two per cent, reaching ?36,399 crore from the previous ?35,787 crore. The fund house strategically lowered its small-cap exposure from 81 per cent in June to 80 per cent in the following month, as per the stress test data from the Association of Mutual Funds in India (AMFI).

The AMFI conducts a stress test after discarding the bottom 20 per cent of the least liquid securities from the portfolio. The aim of this methodology is to provide a more accurate estimate of potential redemptive stress. Similarly, other fund houses like ICICI Mutual Fund, SBI Mutual Fund, Invesco Mutual Fund, Motilal Oswal Mutual Fund, and Bandhan Mutual Fund have witnessed an increase in days required to sell 50 per cent of their small-cap portfolios.

On the flip side, some fund houses like Tata Mutual Fund, Axis Mutual Fund, DSP Mutual Fund, and Franklin India Mutual Fund have reported a slight reduction in the timeframe necessitated to sell fifty per cent of their portfolios. These mutual funds have allocated between 65-87 per cent of their total investments into small-cap stocks.

A stress test of mid-cap Mutual Fund schemes indicated that it could take up to 37 days to liquidate half of the portfolio, and nearly 19 days to liquidate a quarter of it. The rising inflow of funds into mid- and small-cap funds could drive up prices in the short run. However, it also aggregates risk and magnifies fragility should the flow of funds flip.

Trivesh D, COO of Tradejini, opined that the recent stress tests emphasize the underlying challenges faced by some small-cap schemes. Given the tough market conditions, redeeming merely half of their portfolios could take up to 54 days. This scenario underscores the difficulties of exiting during a period of market uncertainty.

Trivesh D further counseled that inflated valuations could tempt novice investors to make expedient profits and momentum-driven choices. However, these investors must resist the urge to rush into such decisions. Even in a bull market, they should not forget that the risk of a sharp downturn is always around the corner.

Sonam Srivastava, the Founder and Fund Manager at Wright Research PMS warned of the risk that increased inflows can lead to a sudden spike in asset prices. However, this can also aggrandize risks, making the market more susceptible to shifts in investment behavior. If the pace of inflows continues, stress could intensify even further.

Srivastava further stressed the importance of investor caution in the face of heavy redemptions. She warned that such events can precipitate a steep drop in stock prices, given the limited liquidity available with these counters. Investors ought to maintain a defensive strategy, particularly with small and mid-cap funds, and re-assess their risk tolerance and financial goals regularly.

In summary, the robust inflow into mid- and small-cap mutual funds has presented a unique challenge. This trend has accelerated the time taken to sell a sizable portion of the scheme portfolio and has heightened concentration risk. Fund houses like HDFC Mutual Fund have already been seen adjusting their portfolio to respond to this inflow.

While the quick inflow and exit of investment from mid-cap and small-cap stock have the potential to boost short term profits, market authorities and veterans advise caution. The heightened stress levels in these schemes, signaled by the AMFI, suggest that investors must tread carefully, especially during the period of market volatility.

Investor education is crucial in this scenario. Current and prospective investors must be made aware of the potential risks tied to mid and small-cap mutual funds. Through transparent communication and regular risk assessments, investors can better navigate the complex investing landscape and make more informed decisions.

Overall, the dynamics of the mutual fund industry, especially in relation to mid- and small-cap sections, are intricately complex. Investors, whether seasoned veterans or relative newcomers, need to stay updated and informed about the ongoing market trends and fluctuations. Amid the seemingly enticing opportunity to make quick gains, prudence and patience should be the guiding principles.