The year 2021 belonged to the mid-cap and small-cap stocks. Sustained buying from investors during the year took the Nifty Smallcap 250 index and the Nifty Midcap 150 index to an all-time high level of 10,014 and 12,219, respectively on October 18, 2021. A broad-based market rally during the year meant that Mid-cap Funds and Small-cap Funds outperformed Large-cap Funds by a wide margin (see table below).

On a year-to-date basis, the top-performing Small-cap Fund has delivered an absolute return of 88.5% while the top-performing Mid-cap Fund has grown by 64.6%. In comparison, the growth of top-performing Large-cap Fund was lower at 35.2% during the same period.

However, over the past few weeks, the equity market has turned volatile as Foreign Institutional Investors (FIIs) turned net sellers. Consequently, the mid-cap and small-cap indices are down by around 5%-7% from their peak.

The mid-cap and small-cap indices are likely to witness a further decline in the near term. Here is why:

  1. The Omicron variant is spreading rapidly across the globe, thus raising concerns that we may once again witness stricter COVID-19 restrictions. Though the severity of the new variant is yet to be ascertained, initial reports suggest that available vaccines could be less effective against it. This could potentially delay the economic recovery. As mid-cap and small-cap stocks have a positive correlation with economic growth, any potential setback to the economy can turn investors away from these market cap segments.

  2. The US Federal Reserve has hinted at three rate hikes in 2022 and tapering of stimulus measures amid rising inflation. Other major central banks including the RBI are expected to follow the same in due course. The Bank of England has already hiked interest rate from the record lows. Rising interest rates and normalization of liquidity measures highlight that the equity market could remain under pressure in the near term.

  3. Many mid-and small-sized companies undertook cost-cutting measures to sail through the pandemic-induced financial crisis and recorded robust earnings growth. However, with rising inflation, their earnings growth could get impacted. It can also become difficult for companies in this segment to raise capital.

Table: Mid-cap Funds and Small-cap Funds outperform Large-cap Funds in 2021

Category Top performing fund (%) Worst performing fund (%) Category average (%) Benchmark returns (%)
Large Cap Fund 35.19 16.37 27.15 25.94
Mid Cap Fund 64.57 27.87 45.07 44.99
Small Cap Fund 88.51 35.10 63.98 58.92

Data on YTD basis as of December 17, 2021
(Source: ACE MF)  

Will Mid-cap Funds and Small-cap Funds continue to outperform Large-cap Funds in 2022?

The future course of the pandemic is still uncertain. Moreover, inflation could play a spoilsport for smaller companies making it difficult for them to grow earnings on a sustainable basis. Also, consumer confidence needs to strengthen if mid-and small-sized companies want a consistent earnings show.

As per RBI’s survey, business outlook and consumer confidence have shown improvement due to the government’s infrastructure push, the widening of the performance-linked incentive scheme, structural reforms, recovering capacity utilisation, and benign liquidity and financial conditions.

However, the uncertainty brought by the new ‘Omicron’ variant, higher unemployment rate, pay cuts, and inflation are headwinds to revive consumer sentiments. Possibly, consumer confidence may once again take a beating with people conserving cash and spending mainly on essential items while discretionary spending may take a backseat. This can adversely impact the growth in the equity market in the near term.

To be sure, Mid-cap Funds and Small-cap Funds tend to outperform Large-cap Funds over the long run due to the high growth potential that smaller companies hold. But they can be highly volatile in the short run. When you invest in smaller companies, remember that for every high-potential stock, there is a long list of stocks that can turn out to be wealth destroyers. This is especially true for small-cap stocks. During a market rally, even low-quality names that lack fundamentals begin to soar. However, during market downswings, mid-cap and small-cap stocks tend to plunge lower than large-cap stocks.

Even though the market can bounce back from the current level it would be unrealistic to expect extraordinary returns in the next one year due to the aforementioned factors. Therefore, if you invest in Mid-cap Funds and Small-cap Funds expecting high double-digit returns in 2022, you may be disappointed.

How to approach Mid-cap funds and Small-cap funds now?

Historical data suggests that no particular market cap can be an outperformer every year. Hence, diversification across market cap viz. large-cap, mid-cap, and small-cap is necessary. This will help lower the impact of volatility on your portfolio and thereby earn better risk-adjusted returns.

It is important to note that Mid-cap funds and small-cap funds are high-risk high-return avenues. Therefore, invest only if your risk profile permits.

If you recall, Mid-cap Funds and Small-cap Funds had a similar dream run in 2017. However, in the next two years i.e. 2018 and 2019, Mid-cap Funds and Small-cap Funds not only grossly underperformed Large-cap Funds but the returns also plunged into the negative zone. Most investors who entered the segment post 2017, with the hope of riding the bull-run received nothing but pain in return due to the slowdown in economic growth and the liquidity crisis in NBFCs.

Similarly, investors who expected extraordinary gains in the mid-cap and small-cap segment post the bull rally of 2014 had to satisfy with low single-digit gains in 2015 and 2016.

This shows that equity markets are generally cyclical in nature. Since the equity market has witnessed a sharp run-up in the last one and a half years, the bullish momentum in the equity market could soon reverse.

Graph: Market cap performance differs every year

Graph 1

*YTD as of December 17, 2021
(Source: ACE MF)  

Given that the market volatility could intensify in the near future, devise a strategy and take exposure sensibly depending on your risk profile and financial goals.

Large-cap funds should form a part of the core segment of every investor’s portfolio because they can offer stability and steady growth to your portfolio. Along with it tactically allocate to Mid-cap Funds and Small-cap Funds, depending on your investment horizon and risk profile, to boost your portfolio returns over the long term. But ensure that you avoid investing in Mid-cap funds and Small-cap funds with a short term view. Invest only if you have a long term investment horizon of at least 5-7 years.

If the financial goal for which you have invested is less than 5 years away, you can trim exposure to Mid-cap funds and Small-cap funds. Gradually shift exposure to less risky and stable categories such as Large-cap funds and subsequently to safely managed debt mutual funds and/or bank deposits, etc.

Investors with a moderate risk profile looking to take meaningful exposure in mid-cap and small-cap segments can consider investing in Multi-cap funds, Flexi-cap funds, or Large & Midcap funds. These funds invest across market cap and are less risky than pure Mid-cap funds and pure Small-cap funds.

More importantly, invest only in those mutual funds that focus on picking quality stocks in the mid-cap and small-cap segments. Avoid relying excessively on a fund’s past performance; a top-performing scheme of the past year may not be the top performer in the ensuing year.

This article first appeared on PersonalFN here

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