Mutual funds showing red flags to smallcap investors. Ignore at your risk!

“Regulators are expressing concern about the growing mania in midcap and smallcap segments, prompting them to urge all fund houses to swiftly implement best practices. In my opinion, there is a strong possibility that many funds will be influenced to halt for some time from accepting lump sum investments in these segments,” Abhilash Pagaria of Nuvama Alternative & Quantitative Research said.

SIP flows, however, shouldn’t be impacted as a result of the restrictions.

Several major fund houses are believed to have already begun actively encouraging distributors and investors to consider largecap schemes over mid and smallcap funds.

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Kotak had recently announced that from March 4 fresh subscriptions through lumpsums will be restricted for each investor to Rs 2 lakh per month while SIPs will be limited to Rs 25,000 per month in the smallcap fund.

Among other funds, Mirae Asset Emerging Bluechip Fund has an SIP limit of Rs 25,000.

The move comes on the back of a sharp rally in smallcaps, midcaps as well as microcaps and SME stocks in the last one year. Retail investors have been investing aggressively in smaller stocks directly as well as via the mutual fund route. As a result, the smallcap AUM of have swelled to Rs 2.47 lakh crore - about 11% of the total equity assets under management in the MF industry.

"Retail investors’ ownership of the smallcap segment has also become sizeable, crossing even institutional ownership in many stocks. Institutional investors, like mutual funds, exercise broad controls and invest in a disciplined manner. However, momentum chasing by investors, coupled with limited free float available in the market, has created valuation distortions in a few cases. Such experience is further boosting investors’ confidence, over-shadowing the caution required," Kotak Mutual Fund said.

While India’s market capitalisation-to-GDP ratio is hovering at a lifetime high of 130%, smallcaps' market capitalisation to overall market capitalisation has climbed to 18.9% vs the historical figure of 10%.

High stock price movement in low-liquidity stocks has been a cause of concern, especially in small and midcaps.

"Smallcaps have been valued higher than midcaps and largecaps for quite a while now. And the biggest risk is the fact that if and when the market turns, it is extremely difficult to get out of it due to liquidity. Corporate governance is also an issue in some cases," said market expert Anand Tandon.

Analysts suggest reducing exposure to smallcaps and rely on the safety of largecaps.

Earlier in the week, Sebi asked AMCs to ensure that a policy is put in place to protect the interest of all investors in the context of the froth building up in the small and midcap segments of the market and the continuing flows in the small and midcap schemes. Suggested measures include moderating inflows, portfolio rebalancing, etc. Mutual funds have also been asked to take steps to ensure that investors are protected from the first mover advantage of redeeming investors.

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(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)