smallcap fund: Mid & smallcap fund? Do we need a new category targeting both mid and smallcap stocks

Since the beginning of 2024 large and midcap category has seen inflows of Rs. 11,340 crores followed by multicap category at Rs. 10,004 Cr. and the flexi-cap category at Rs. 9,971 crore, higher than the inflows in largecap, midcap and smallcap categories respectively. Interestingly, this data highlights that despite presence of each distinct category, investors are also keen on funds that provide combined exposure to multiple market-cap segments. This is because such funds cater to a larger opportunity set to create portfolios, which may be more diversified, might have superior risk-adjusted returns and address the question of how much and when to allocate within which segment. While the Indian mutual fund industry has evolved over the last decade, it has certainly missed one such market cap combination, a mid-small cap fund that gives you exposure to mid-caps and small-caps collectively. A single fund giving exposure to mid-caps & small-caps can potentially offer the same benefits like we see in other combined market cap categories.

Currently, AMC’s cannot launch such scheme on the active side, as this category has not been defined by SEBI, but no such restriction exists on the passive side and perhaps such passive funds can address investor requirements like a portfolio that captures the best of both segment, the allocation between mid-caps and small caps and a return participation with better risk containment. Now, even on the passive side, it might be prudent to construct a small-cap and midcap portfolio with quality assessment, identification of companies with return potential and addressing liquidity challenges.

One such index provided by NSE is the Nifty Midsmallcap 400 Momentum Quality 100 Index. The Index, as the name suggests considers the entire mid and smallcap universe of 400 stocks and then by applying liquidity, quality, and momentum criteria’s, selects 50 mid-cap stocks and 50 small-cap stocks to create a 100-stock portfolio. The Index gets reviewed semi-annually with a maximum stock cap of 5%. Under liquidity criteria, the index excludes thinly traded stocks, stocks with high promoter pledging and less listing history and the ones hitting price circuits too often. Under the quality parameter, the index looks for stocks with higher profitability, earning stability, and lower leverage. Momentum assessment is based on identifying companies delivering higher risk-adjusted returns in the last six months and 12-months period. The index has on average allocation of 70% – 80% to mid-cap stocks and 20% – 30% weightage to small-cap stocks.

By targeting two complementary factors, i.e. quality and momentum, the index seems to be focusing on generating alpha with stability during market turbulence. The data shows that this new index is delivering better returns in the long run, but does so with better risk-adjusted performance, which may appeal to investors who are seeking a single solution to Midcap and Smallcap investing.

Source: NSE Indices Limited, Data as of March 31, 2024; Past performance may or may not be sustained in the future. Not only on a point-to-point basis, but historically on a rolling basis, the index has done reasonably well as it seeks to capture alpha with momentum factor and lower drawdown with quality factor.

Source: NSE Indices Limited, Data as of March 31, 2024; Past performance may or may not sustain in the future.

If we compare the performance of the index vis-a-vis actively managed mid-cap funds (Direct plan) then as of April 30, 2024, on 10 Yr. basis, all midcap funds are underperforming the index. The actively managed funds have generated an average return of 21.5% return v/s 24.5% generated by the Nifty Midsmallcap 400 Momentum Quality 100 Index. This index has outperformed the parent Nifty Midsmallcap 400 Index in the last 13 out of 18 calendar years, though it has to be noted that these factors may relatively underperform in certain market cycles.

To summarize, if you see from 2009 to 2023, in the last 15 calendar years, midcap index has been a winner in 3 calendar years and smallcap index has been a winner in 7. In hindsight it is easy to identify, but predicting the same is very difficult, i.e. in which year which segment will do well, which is why a combined mid-small fund may make sense. Thus, investors with an investment horizon of 5-7 yr. can potentially look at options in this space especially those who are looking for single option to capture the potential of midcaps and small caps with benefits which such funds bring to an investor’s portfolio.

(The author is Siddharth Srivastava, Head – ETF Product & Fund Manager, Mirae Asset Investment Managers)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)