Mid and small cap mutual funds are equity mutual fund schemes which invest primarily in stocks belonging to the midcap and small cap market segments. Stocks with market capitalizations ranging from Rs 2,000 to Rs 10,000 Crores are classified as midcap stocks, while stocks whose market capitalizations are below Rs 2,000 Crores are classified as small cap stocks. The universe of mid and small cap stocks is very large, but expert fund managers can find excellent investment opportunities in the mid and small market capitalization segments.
Mid and small cap equity mutual funds are usually perceived to be more risky than large cap equity mutual funds. Given their smaller size, small and mid cap companies tend to suffer more in economic downturns because they lack the economic resources which large cap companies have during demand slump in the economy. In past bear markets, especially during the financial crisis of 2008, investors dumped small and midcap stocks at the slightest signs of trouble (bad news) and the price damage can be severe in these stocks when panic sets in;in some stocks, it can take a long time for the price damage to be reversed.
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Mid and small cap stocks in India usually have a relatively small base of free floating shares, i.e. shares not held by the promoters, related parties or the management. The smaller base can cause liquidity problems, especially in very volatile market situations. Sometimes in bad bear markets, when panic strikes, investors rush to redeem their small and midcap equity mutual fund investments. When redemption pressures are extreme, mutual fund managers may not find enough buyers for these stocks in the market and therefore may not be able to sell at times.
However, in India, mid and small cap mutual funds have historically given the highest returns among all equity mutual fund categories. This is because these companies have the potential to grow faster (in terms of revenues and earnings per share) in percentage terms than large cap companies because of their smaller base. Small and midcap companies are also considered to be more nimble, with the ability to react faster to new market opportunities compared to their large cap counterparts.
It has also been observed in more recent times, especially during the bear market of 2015 / early 2016, that small and midcap stocks are less affected by deterioration in global risk sentiments compared to large cap stocks. Foreign Institutional Investors account for a large percentage of volumes traded in Indian stock markets. Foreign Institutional Investors invest mostly in large cap stocks and their activity mostly impacts large cap stocks. As long as sentiments of domestic investors (institutional and retail) remain positive, midcap stocks and mutual funds tend to remain unaffected by global factors.
Small and midcap stocks tend to be under-researched and therefore, their valuations tend to be lower than large cap companies. However, investors can create a lot of wealth in these stocks over long investment tenures through both rapid earnings growth and also valuation re-rating (upgrade) over a period of time. Growing midcap companies at some stage may become large cap companies and may be valued as such; since midcap companies usually trade at a discount (in terms of valuations) to large cap companies, the valuation upside and capital appreciation potential in these stocks can be quite substantial.
When investing in small and midcap stocks, it is essential for investors to invest in high quality stocks, i.e. stocks which have business model strength, growth potential, ability to generate good free cash-flows and return on capital employed. As discussed earlier, the universe of small and midcap stocks is vast and less is known about these companies compared to large cap companies. Therefore, the task of selecting high quality midcap stocks, which are potential multi-baggers, can be quite difficult. However, top fund managers have the expertise and experience in identifying such stocks. Top performing mid and small cap equity mutual funds have given more than 25% returns in the last 5 years.
Systematic Investment Plans are the best investment modes for mid and small cap equity mutual funds for salaried investors because they can invest in a disciplined way from their regular monthly savings instead of waiting to accumulate a lump sum amount. Through Systematic Investment Plans, investors can also take advantage of stock market volatility through rupee cost averaging.
Since midcap equity mutual funds tend to be more volatile than large cap equity mutual funds rupee cost averaging along with the power of compounding can give excellent returns to investors in the long term. However, in addition to systematic investment plans, if investors have lump sum funds available, they can tactically take advantage of market corrections, which can at times be quite sharp for small and midcap funds,to increase the asset allocation of equity in their overall investment portfolio by investing in small and midcap equity mutual funds.