After a stark underperformance in 2018 and 2019, small cap funds and mid cap funds have clearly outshined other mutual fund categories over the last two years. In the last one year, small cap funds on an average have delivered 62% and mid caps have given an average 42% returns. The highest return generated by the small cap mutual funds is over 90%. Even the worst performer in the period under consideration has delivered 32% returns. Mid cap schemes have grown in the range of 30% and 60%. Will the stellar performance of these two categories continue? Should you invest more or book some gains?

A report by Edelweiss Mutual Fund says there exists a bigger opportunity for alpha generation in mid and small cap funds. Average number of analysts covering large caps is 31, as per the report, and midcaps are 18, while small caps are relatively under-researched. Out of top 1,000 companies by market capitalisation, 328 stocks are not covered by any analysts and 302 stocks are covered by less than five analysts. “This gives fund managers an edge in spotting good businesses early and generating higher alpha,” says the Edelweiss MF Report.

Mid caps have outperformed the large cap category in the long term. Since inception, while Nifty 50 (large caps) has grown by a CAGR of 13.3%, NSE Nifty Midcap 100 has given 16.7% CAGR. Also, with a CAGR of around 16% in the last 20 years, they have delivered positive returns in 14 out of 20 years. However, higher returns come with a comparatively greater risk and those having a conservative risk appetite should not invest.

“Asset allocation basis risk appetite of the investor should be the guiding principle for an investor’s portfolio construction,” says Rahul Roy Chowdhury, Business Head-Wealth, Equirus. He adds those interested in investing in mid cap and small cap categories should base their decision on their risk profile.

Also, investors should get in mid and small cap categories with a long time horizon. "The volatility in small cap stocks will be the highest and that of large cap stocks the lowest; similarly the drawdowns (maximum loss from peak stock prices) in small caps are higher than in large caps," says Lovaii Navlakhi, chairman, Association of Registered Investment Advisors (ARIA). Hence, he adds, to smoothen the investment journey and give time for returns to be generated, the time horizon for investing needs to be longer in small cap stocks.

"Investors should invest with a longer time horizon of at least 4 to 5 years with a staggered approach,” says Chowdhury of Equirus.

Investors may invest via Systematic Investment Plan (SIP). Those who want to invest a lumpsum, may go through a 3 to 6 months Systematic Transfer Plan (STP) to benefit from any near term volatility. STP is a strategy where an investor transfers a fixed amount of money from the source scheme to target scheme (usually from a debt fund to an equity fund).

For existing investors, Chowdhury believes, it is time to book some profits and freeze the returns. “With the sharp outperformance seen in small and midcap funds, this would be an opportune time for investors to re-balance their portfolio by doing partial profit booking and re-aligning their portfolios to the desired allocation towards mid and small caps basis their risk appetite,” he says.

The other way to make a redemption decision is to question yourself, 'What was the expected returns from the investment when one entered?' If there are excessive returns, it is always good to take some profits, says Navlakhi, off the table so that the risks can be reduced. Further, "if any goals are coming up in the near future and liquidity is not otherwise in place, reducing equity exposure is warranted," he adds.

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