Mid- and small-cap funds: Time to be watchful

Since we last connected, the mid- and small-cap indices had already rallied quite 'a lot'. Continuing with the trend, in the second half of 2023, the small-cap index gunned out 30.3 per cent returns, followed by mid-caps at 27 per cent and Sensex delivering a modest 14 per cent. How's the josh (read inflows)? High, Sir! Rs 64,000 crore! That's how much investors collectively pumped into the mid- and small-caps in 2023, accounting for 40 per cent of the total flows in 2023 across all equity funds. It appears that investors are trying to chase momentum, drawn by the allure of the recent rally and the impressive performance numbers. The trend suggests an intense 'fear of missing out' (FOMO) among investors eager to join the party. But it's important not to underestimate the risks involved. While mid- and small-cap funds can provide skyrocketing returns, these are prone to sharp declines. For instance, in 2008, small-cap funds fell by 57 per cent, leading to a significant loss of wealth for investors. However, these funds delivered a 94 per cent return in the following year (2009). This aptly sums up the roller-coaster nature of small-cap investing. Assessing the small-cap funds' portfolio Usually, when flows into mid and small-cap funds start burgeoning, fund managers are forced to dilute the focus by getting into slightly larger-cap stocks, or they are compelled to go down the quality curve. This is undoubtedly not a comfortable situation to be in. Using our recently launched Value Research Stock Ratings , we analysed the current Quality, growth potential, and valuations of small-cap fund holdings. As evident from the graph, the Quality of small-cap fund portfolios remains intact. In fact, their investments in moderately high to high-quality businesses have only risen compared to a year before. These