Small-cap index sees rout amid froth-building concerns: Should mutual fund investors exit?

Nifty Smallcap index on Tuesday (March 12) witnessed around 10% decrease from its peak on February 8, when it reached 16,691. This comes on the back of Securities and Exchange Board of India's (SEBI's) statement regarding creview of the rule that mandates small-cap funds to invest a minimum of 65% of their assets in such stocks.

The regulator's comments come amid markets showing signs of overheating due to a boom in the nation’s equities.

Speaking on the same, Mihir Vora, Chief Investment Officer at Trust Mutual Fund, on Tuesday (March 12) emphasised the need for caution.

Vora stated, "Froth has been building up, and the regulators have, in a timely way, identified the pockets of risk and necessary corrective actions were already taken."

Vora highlighted the responsible approach taken by mutual funds, stating, "More transparency is always better."

"Both regulators and mutual funds have responsibly communicated the necessity to exercise caution in small-cap investments. I don't foresee any significant disruption, and I firmly believe that increased transparency is always advantageous," he told CNBC-TV18.

He pointed out that various mutual funds have already taken steps to control inflows into small caps, with some funds restricting lump sum investments and allowing only systematic investment plans (SIPs) to a certain extent.

He added that the limited impact of the correction in the micro and small-cap segment is not a systemic concern, given the substantial increase in market capitalisation.

Addressing concerns of overheating in certain segments of the market, SEBI Chairperson Madhabi Puri Buch recently announced a review of the investment rules for small- and mid-cap funds.

The regulatory body has urged fund managers to take measures to protect investors from potential risks associated with the rising interest in these stocks.

Last month, Kotak Mutual Fund announced restrictions on lumpsum investments in its small-cap funds.

Fresh lumpsum investments, including additional investments or switch-ins, have been capped at ₹2 lakh per PAN (first holder or guardian) per month.

Systematic Investment Plan (SIP) and Systematic Transfer Plan (STP) registrations will continue with a monthly limit of ₹25,000 per PAN for various frequencies, the fund house said.

Kotak Mahindra Mutual Fund highlighted the multiplication of certain small-cap and mid-cap stocks, leading to momentum-driven valuation distortions.

Notably, SBI MF, Nippon India Life Asset Management, and Tata Mutual Fund have taken similar measures in the recent past.

In the last 12 months, small-cap funds have seen significant net sales of ₹42,037 crore, while midcap funds attracted ₹23,346 crore as of February 2024.

In contrast, large-cap funds experienced outflows of ₹2,397 crore.

The small-cap category received the highest inflows in 2023, totalling around ₹41,035.49 crore, fueled by returns that averaged approximately 41.08%.

In a recent evaluation by Value Research, four small-cap funds have demonstrated stellar performance, surpassing their benchmarks over the last 12 months.

As of February 23, 2024, the returns and assets under management (AUM) figures as of January 31, 2024, reveal the success of these funds.

Given the current market dynamics and the cautious stance advocated by industry experts, investors in small-cap stocks may want to approach with careful consideration.

While small-cap investments have shown significant returns in the past, the recent scrutiny by regulators and proactive measures taken by mutual funds suggest a need for prudence.

Investors should weigh the potential risks associated with market froth and overheating, as highlighted by SEBI.

Conducting thorough research, diversifying portfolios, and aligning investments with long-term goals remain crucial aspects for those contemplating small-cap investments in the current scenario, experts say.