My Money: Catching the Growth Wave with Small-Cap and Mid-Cap Funds – Business

The Indian mutual fund (MF) industry has experienced impressive growth in recent years, with assets under management (AUM) exceeding Rs 54.5 lakh crore. This surge is primarily driven by the increasing participation of young investors and the popularity of systematic investment plans (SIPs). In February, Systematic Investment Plan (SIP) contributions reached an unprecedented milestone, with investors pouring in a record-breaking Rs 19,186.58 crore.

Several factors contribute to this exponential growth. Firstly, the widespread adoption of digital technology has made it easier for investors to access and manage their MF investments, particularly in smaller cities. This democratization of access has been vital in driving the industry’s expansion. Secondly, the growing financial literacy among the younger generation has made them more aware of the benefits of long-term investing, further boosting the popularity of SIPs.

The industry’s growth trajectory is evident when comparing the current AUM with the figure from five years ago, which stood at Rs. 22.26 lakh crore. Over the past decade, the mutual fund industry in India has experienced a five-fold increase in AUM, making it the second-largest in the world and one of the fastest-growing markets.

The Securities and Exchange Board of India (SEBI) has encouraged mutual fund houses to promote their schemes in B-30 cities, increasing contributions from these areas. With lower financial literacy levels and a less mature financial market, B-30 cities hold significant growth potential. As awareness of financial products increases, these cities will likely play an essential role in the industry’s expansion.

The top 10 fund houses or asset management companies (AMCs) manage over 70% of India’s total mutual fund assets, indicating the dominance of a few key players in the industry. As the AUM is projected to grow from USD 0.66 trillion in 2024 to USD 1.51 trillion by 2029 at a CAGR of over 18%, the Indian mutual fund industry is expected to continue its impressive growth trajectory.

Vijay C Roy

India’s mutual fund (MF) industry has experienced significant growth, with assets surpassing Rs 54.5 lakh crore. The driving forces behind this expansion are young investors and systematic investment plans (SIPs). In February, SIP contributions reached an all-time high of Rs 19,186.58 crore, representing a notable increase compared to January’s Rs 18,838.33 crore.

The rise of digital technology has facilitated access and management of MF investments, attracting young investors in smaller cities. Additionally, growing financial literacy among the younger generation has led to greater awareness of long-term investment benefits, fueling the popularity of SIPs. These trends indicate that the Indian mutual fund industry is poised for continued growth. SIPs are increasingly vital to its expansion.

Rajeev Kathuria, a mutual fund distributor, attributes the craze for MFs to handsome returns compared to traditional savings instruments like PPF, FD, or bank deposits. “Secondly, it’s a low-cost product, and the investment starts at Rs 500 per month, and an investor can also get tax benefits.” Most investors, he says, have to be educated about small and mid-caps as the industry is still marred by low financial literacy.

Over the past three years, mutual funds investing in small-cap and mid-cap stocks have become increasingly popular among investors. Small-cap stocks are companies with a market capitalization below Rs 5,000 crore.

In 2023, small and mid-cap schemes accounted for 40% of the total net inflows into active equity schemes, amounting to Rs 64,000 crore of the total Rs 1.6 trillion inflow. These substantial inflows prompted fund managers to acquire more small and mid-cap stocks, further bolstering the growth of these investment vehicles. With continued investor interest and inflows, the popularity of mutual funds focused on small and mid-cap stocks is expected to remain strong in the foreseeable future.

Recent developments have raised regulatory concerns regarding liquidity in the small and mid-cap segments. In response to the growing mutual fund (MF) investments in these stocks, the Securities and Exchange Board of India (SEBI) urged fund houses last month to stress-test their schemes. The aim was to evaluate their ability to handle sudden increases in redemptions. This led to a correction in small and mid-cap stock prices and the leveling of net asset values (NAVs) of funds.

In the previous calendar year, the small and mid-cap segments witnessed a significant rally, with returns reaching 48% and 43%, respectively, driven by high liquidity as investors sought attractive returns, according to Anand Rathi Wealth Limited. However, since the third week of March, small and mid-cap stocks have experienced a sharp decline due to selloffs triggered by SEBI’s apprehensions over potential frothiness in these segments. SEBI’s remarks on the exceptional performance and elevated valuations of small and mid-cap stocks led to market speculations about possible restrictions on fund allocation, ultimately disrupting market sentiment.

“The crisis mushroomed from a number of factors, notably a heightened risk-aversion factor due to geopolitical uncertainties and overinflated stock values for small-cap stocks. SEBI’s stress test for mid-cap and small-cap mutual funds also increased pressure on these indexes,” says Gurmeet Singh Chawla, director at Master Capital Services Ltd.

SEBI’s Warning

Last month, Madhabi Puri Buch, the Chairperson of the Securities and Exchange Board of India (SEBI), expressed concerns over the “froth” in small and mid-cap stocks due to their “off the charts” valuations. She highlighted that such valuations could indicate price manipulation in the small and medium enterprises segment. Buch also mentioned that SEBI is open to reviewing the norms that require small and mid-cap funds to invest 65% of their assets in these stocks.

According to Chirag Mehta, the Chief Investment Officer at Quantum AMC, SEBI’s directive came after initial stress tests on small-cap and mid-cap schemes with significant assets under management (AUM). These tests were conducted to assess the ability of these schemes to handle substantial redemptions in the event of a market downturn. As SEBI continues to monitor the market and evaluate potential risks, it remains to be seen how these concerns will be addressed and what impact they may have on future regulations.

“SEBI is looking to ensure that during phases of market downturns and the resultant surge in outflows, the first set of investors shouldn’t be at an advantage, leaving those staying invested with low liquidity,” he says.

In response to SEBI’s concerns, the Association of Mutual Funds in India (AMFI) has issued a directive to mutual funds. The directive instructs mutual funds to conduct stress tests every 15 days and publicly disclose the outcomes. This move aims to enhance transparency and enable investors to make more informed decisions.

Before this, SEBI had requested asset managers to provide investors with additional information about the risks associated with small and mid-cap funds. The increased focus on stress testing and risk disclosure demonstrates the regulator’s commitment to safeguarding investor interests and promoting stability within the mutual fund industry.

No Need to Panic

According to Chirag Muni, executive director at Anand Rathi Wealth Limited, the stress test has brought clarity and investors do not need to panic. “This was a hypothetical crisis scenario created by SEBI. In the last 10 days, the mid-cap and small-cap segment has started recovering, with 3.9 percent and 6.7 percent returns. The categories are seeing an inflow in April after some outflow in March.”

In this fiscal year, while some small-cap stocks appear to be stretched, others still hold a significant growth potential. “We expect a good performance from select mid and small-cap entities,” says Chawla.

Chirag Muni is of the view that stress tests will be expected in the future to understand if the funds have improved their position. “We expect that asset management companies might restrict inflows in these categories and SIPs might pick up, which will regularise the liquidity. 

Investors need not worry and should create a balanced portfolio by investing across categories and market cap. A mix of 50-60 per cent in large-cap and rest in mid-cap and small-cap would be most ideal,” he adds.

According to Shashank Pal, chief business officer-wealth and investment products, Prabhudas Lilladher, “Mid and smallcap stocks fell in mid-March due to a combination of factors. On one hand, SEBI highlighted that froth is building up. It also directed AMFI to conduct stress tests. 

This made investors nervous and prompted many to exit, which pushed prices downwards.” On the other hand, he says, RBI issued directives against certain NBFCs, asking them to halt IPO financing and loans against shares. This could have impacted liquidity in the system.

According to Shashank, it may not be accurate to say that the fall has ended because mid and small-cap stocks inherently exhibit higher volatility and price swings. In the shorter term, they will continue to remain highly volatile and sensitive to all kinds of news affecting the markets. “Once the impact of the news or event is assessed and adequately factored in, the stocks begin to take direction.”

The emergence of new-age enterprises is expected to further contribute to the growth of the small and mid-cap segment. In their early stages of development, these innovative companies will fall under the classification of small and mid-cap stocks until they achieve substantial growth, marked by predictable, large, and stable cash flows. Over time, as these enterprises evolve and solidify their market positions, they may eventually transition into the large-cap space.

This dynamic underscores the importance of the small and mid-cap segment as a fertile ground for nurturing the next generation of industry leaders. Moreover, it presents opportunities for investors seeking exposure to promising, high-growth companies that have the potential to transform their respective industries and deliver significant long-term returns.

“Over longer periods such as three years, five years, and 10 years, mid and small-cap indices tend to outperform the Nifty 50 and Nifty 100 on a CAGR basis. Therefore, investors should not have a short-term horizon when investing in these stocks. They should be patient and allow investments to reap rewards over time,” Shashank adds.

What is a Stress Test

Stress testing is crucial in determining investments’ resilience during market turbulence. It helps gauge the time it would take for an investor to recover their investment in the event of a market downturn and increased redemption pressures. Mutual fund companies employ stress tests to evaluate the liquidity of their small and mid-cap portfolios, ensuring they can meet potential redemption obligations during challenging market conditions.

Similarly, the Reserve Bank of India (RBI) conducts semi-annual stress tests on banks to assess their ability to withstand stress scenarios and maintain adequate capital and liquidity levels. These tests are vital in identifying vulnerabilities and ensuring the financial system’s stability. By evaluating the resilience of financial institutions and investment vehicles, regulators aim to safeguard investor interests and mitigate potential risks from market volatility.

Mutual fund Chronology

The Mutual Fund (MF) sector has evolved significantly since its inception, with notable developments and regulatory changes shaping the industry over the years:

1963: The formation of the Unit Trust of India (UTI) marks the beginning of the MF sector. By the end of 1988, UTI managed assets worth Rs 6,700 crore.

1964: Unit Scheme 1964 (US’ 64) became the first scheme launched by UTI.

1987: Public sector banks, LIC, and GIC enter the market with their own MFs. SBI Mutual Fund is the first non-UTI MF, followed by Canbank Mutual Fund and PNB Mutual Fund, among others. By the end of 1993, the industry’s assets under management reached Rs 47,004 crore.

1993: The Securities and Exchange Board of India (SEBI) introduces its first set of regulations for MFs, exempting UTIs.

July 1993: Kothari Pioneer, now merged with Franklin Templeton MF, registers as the first private sector MF. The industry’s growth continues, with 33 MFs managing Rs 1,21,805 crore by January 2003.

2009: The global economic meltdown shakes investor confidence in MF products as securities markets plummet.

September 2012: SEBI introduces revitalizing measures to boost the MF industry.

2017: Following demonetization, liquidity-flush banks reduce fixed deposit rates while equity markets achieve record highs.

The MF sector has witnessed remarkable growth and transformation throughout its history. It has adapted to economic challenges and regulatory changes to better serve investors and drive financial prosperity.

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