Should you invest in mid-cap and small-cap funds in the current stock market?

Indian stock markets have become highly volatile after foreign institutional investors started exiting them in October 2021. The stock markets further crashed after the Russian invasion of Ukraine sent International crude oil prices soaring. It is bad news for India, which imports more than 80% of its energy needs. Retail inflation is surging, and the RBI has hiked interest rates to bring it under control. Under such extreme market conditions, should you invest in mid-cap and small-cap funds?

What are mid-cap and small-cap funds?

Based on the Securities and Exchange Board of India (SEBI) classification, mid-cap funds must have a minimum investment of 65% of total assets in equity and equity-related instruments of mid-cap companies. Mid-cap firms have a market capitalisation between Rs 5,000 crore to Rs 20,000 crore. 

On the other hand, small-cap funds must have a minimum investment of 65% of total assets in equity and equity-related instruments of small-cap companies. Small-cap companies have a market capitalisation under Rs 5,000 crore. 

Small-cap funds performed well from May 2020 to May 2021. The Nifty Smallcap 100 TRI, the benchmark index for small-cap mutual funds, gave stellar returns of 114% in this period. Mid-cap funds, too, performed exceptionally well over this time. 

Should you invest in mid-cap and small-cap funds in the current stock market?

You must invest in mid-cap and small-cap funds only if you are a market-savvy investor who understands the investment. Moreover, these investments are suitable if you have higher risk tolerance. For instance, small-cap mutual funds generated an average return of 60% in 2021. However, they gave negative returns in 2019 and underperformed in 2018. 

Mid-cap and small-cap funds have lost significant value after the Russian invasion of Ukraine. For instance, the small-cap index crashed by around 20% in May 2022 from its January 2022 highs. The mid-cap index too saw a significant fall in this period. 

Mid-cap and small-cap indices are available at a significant discount to what they were a few months back. You may consider this a good entry point if you are a market-savvy investor looking to diversify your portfolio with small-cap and mid-cap funds. 

However, mid-cap and small-cap funds may not do too well in the near future. You must invest in them only if you have a time horizon of over five years. These funds invest in smaller-sized companies that take time to generate sizable profits. 

Mid-cap and small-cap funds may do well in a bull market. However, they underperform when stock markets crash. Do not redeem your mid-cap and small-cap funds in a panic if they have fallen due to the current market crash. Give them time and see how they would perform when the stock market rises. Otherwise, you will suffer heavy losses.

Keep these points in mind when picking mid-cap and small-cap funds for your portfolio. For instance, it helps to choose mid-cap and small-cap funds with a lower expense ratio which is the cost of managing the fund. It helps increase overall returns over the long run. 

You may consider picking mid-cap and small-cap funds that consistently outperform their benchmark indices and peers. Moreover, you must check their performance in a bear market. It gives you an idea if these mid-cap and small-cap funds can manage downside risk in a bear market. 

You must check the mid-cap and small-cap funds portfolio to see in which companies they invest your money. Make these funds a part of your satellite portfolio rather than your core portfolio. It forms a small part of your portfolio and enhances overall portfolio returns.

For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@clear.in

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