Will mid and small cap sector bubble burst?

2023 has been a stellar year for small-cap funds. Small-caps saw funds worth flowing in during August 2023. On the other hand, investors withdrew Rs 348.98 crores from large-cap funds last month. However, the investor’s exuberance for small-cap funds stems from the benchmark beating returns generated by small-cap funds over the last few months.

As per data from Value research, small-cap funds have generated a whopping 20% returns over the last 3 months. Compare this to BSE Sensex, which has delivered only 6.85% returns during the same period. Even large-cap funds have generated 9.26% returns over the last 3 months.

Melvyn Santarita, Analyst at Morningstar India notes that over the last 6 months, small cap indices have witnessed a stellar rally. That is why investors are rushing to buy small-cap funds. These funds have the potential to deliver high returns, but remember, they are also extremely vulnerable to market swings. However, active large cap funds have been finding it increasingly difficult to beat passive funds, which might be why investors are exiting these funds.

Now, let us understand the current situation of large-cap funds.
Investors have largely been moving away from large-cap funds in 2022. Take a look at the net inflows and outflows in both small and large cap funds this year.

Data suggests that investor interest in small-cap funds was at an all-time high between April and June 2023, when investors put in Rs 10,936.7 crores in these funds. However, the massive fund inflows have somewhat tapered now. That is because prominent asset management companies like Tata and Nippon put a hard stop to any fresh fund inflow for its small-cap funds.

This is because at present, there is a serious lack of good investable opportunities in the small and mid-cap space.

A recent research by Kotak Institutional equities notes that many mid and small-cap stocks have witnessed a steep rise which seems disconnected from their fundamental factors. Instead, it appears to be driven by investor irrationality.

The report further states that there has been no meaningful change in the fundamental factors of most companies. In fact, in most cases, they have only worsened.
Now, it seems that the market is listening. Both midcap and small-cap indices recorded their worst fall in 9 months on 12th September, 2023. In such a situation, you cannot ignore large-cap funds anymore.

This is because large cap funds offer a strong foundation to your portfolio, since it has stocks from top 100 listed companies by market capitalization. Given their market reputation and financial stability, these companies promise strong, consistent revenues and stable returns.

On the other hand, small-cap funds are extremely susceptible to market swings. According to the Kotak report, there seems to be an ever-widening gap between how small cap companies are being seen by the investors, and how they are actually performing. However, once the actual valuation of companies and their stock prices reconcile, small-cap funds could be amongst the first to crash.

Financial Planner Sanjeev Dawar says that only after your core portfolio has adequate large-cap funds should you gradually venture into other segments like mid and small cap funds. This is to reduce the risk of capital erosion and high volatility in short term