Over the last 4 years, small cap funds and mid cap funds have actually done extremely well. However, post the Union Budget 2018, mid cap funds and small cap funds have underperformed. If you look at the indices on the NSE, the NSE Nifty is down by 4% since the Union Budget while the mid-cap index is down by 7%. During the same period, the small cap index is down sharply by 16%. That surely creates room for doubt in the minds of small cap and mid cap investors. Is investing in small and mid cap funds really worthwhile or should investors exit from these funds? When to sell small and mid cap funds is the real question. But the bigger question that investors are asking is whether I should invest in small cap funds. Here are some key take-aways..

 

Keep your small cap funds in perspective

What do we understand by keeping your small cap funds in perspective? When you decide upon your equity fund allocation, you allocate your monies across large cap, mid cap and small cap funds. Typically, your mix should be in the range of 70:20:10 in favour of large cap funds. This will ensure that you have the benefit of diversification with the power of alpha from mid caps and small caps. You should ensure that whenever your small cap and mid cap allocation diverges from this level by more than 5%, it is time to reallocate and bring it back to their original level. When you adopt this rule-based approach, you will automatically be safe in mid-caps and small caps. Perspective is very important.

 

Focus on credible mid cap and small cap stories

The mid cap fund and small cap funds can be quite a heterogeneous unit. It is hard to really benchmark against an index. The best way is to drill deeper into the portfolio of these mid cap and small cap funds. Check the portfolio and whether the stocks in their portfolio are speculative or stable stocks. Focus on stocks that are profitable and have reliable business models. There is lot of information about companies that is available on the net and you can use this information to get a clear idea of what the portfolio composition really means. When it comes to small cap and mid cap funds, the quality of the portfolio matters a lot.

 

De-risk your mutual fund portfolio with multi-cap funds

This is quite an interesting approach to handling the risk of mid cap and small cap stocks. These stocks are, by default, quite risky. The challenge is that as an individual there is only so much that you can glean from the portfolio of these funds and there is only so much that you can do. An easier method will be to shift to multi-cap funds. These multi-cap funds invest in a mix of large caps, mid caps and small caps; so they automatically give you the benefit of diversification with the scope for alpha. That could be one alternative, especially if you want adopt a more passive approach to mid cap and small cap investing.

 

Weed out the high debt and high equity names

While low debt and low equity is value accretive for all kinds of stocks, this is more pronounced in case of small cap and mid cap stocks. Most mid cap and small cap names are focused on a single line of business or are dependent on a small set of customers. Hence higher financial risk of debt or high dilutive impact of equity can be quite dangerous for such companies. When you evaluate the portfolio of your mid cap and small cap funds, check out if any of the major holdings of these funds has a financial risk or dilutive risk. It is always better to stay away from funds that have a large chunk of their monies invested in such high debt or high equity stocks.

 

Finally,  past returns and consistency are rarely wrong
When you have to choose between two mid cap funds or small cap funds, what exactly do you rely on? The answer lies in past returns, outperformance and consistency of returns. It is said that the past does not portray the future but then the past is rarely wrong. For example, if a fund has underperformed the index for 8 quarters on a rolling 3 year basis then it is highly unlikely that it will outperform in the future. Apart from rolling outperformance, also look for consistency of returns. A mid cap fund that gives returns of 15% annualized is far better than another fund that gyrates between positive and negative returns but ends up giving the same return after 5 years. In this business of mid caps and small caps, consistency matters a lot!