Younger investors with long investment horizons may continue their SIPs.
S Naren, executive director and chief investment officer, ICICI Prudential Asset Management Company, set the proverbial cat among pigeons recently.
Addressing a gathering of distributors, he warned that systematic investment plans (SIPs) initiated after 2023 in midcap and smallcap funds face the prospect of poor returns over the medium term.
Naren highlighted that valuations in these segments are at absurd highs, market capitalisation is significantly high compared to profit-after-tax contribution, and momentum has weakened recently.
He pointed out that since investors are averaging at elevated valuations, medium-term returns could be low.
Amid slowing earnings growth and multiple risks in the global environment--wars, trade conflicts, the possibility of an interest rate cycle reversal, and fund pullout by foreign institutional investors -- investors need to take this veteran fund manager's warnings seriously.
Risk posed by elevated valuations
Financial advisers agree that valuations in mid-and smallcap segment are stretched.
"They have been so since the end of 2023. The markets are rarely fairly valued, but in mid and small caps the pendulum tends to swing to greater extremes," says Deepesh Raghaw, a Securities and Exchange Board of India-registered investment advisor.
Some fund managers, however, believe that the correction since September 2024 has partially mitigated valuation excesses.
"Current levels, however, may not yet be highly attractive, given the cautious corporate outlook and rising global uncertainties," says Vinit Sambre, head of equities, DSP Mutual Fund.
Large AUMs, low liquidity
Fund managers say fund size is not a major concern.
"While the assets under management (AUM) of mid- and smallcap funds have grown, so have the companies within these segments," says Sambre.
According to the latest classification, midcap companies now have market capitalisation ranging from Rs 33,000 crore to Rs 1 lakh crore," adds Sambre.
The addition of new companies and sectors has broadened investment opportunities, he points out.
Sambre acknowledges that liquidity is a concern in mid- and smallcap stocks compared to largecaps, and it gets exacerbated during downturns.
However, he sees a silver lining.
"Liquidity constraints may force investors to sell stocks at lower prices, creating mispriced opportunities," he says.
Others, however, worry about liquidity challenges. During market downturns, liquidity tends to dry up, making exits difficult.
"The risk is higher for small-cap funds, which deal with stocks that are not frequently traded," says Atul Shinghal, founder and CEO, Scripbox.
"The portfolio must be well diversified, or else the impact cost while liquidating these stocks can be very high," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Diversification, however, poses its own challenges in larger-sized funds.
"Finding more quality stocks and then monitoring all of them becomes a humongous task," says Raghaw.
Ongoing SIPs: Stop or continue?
Investors running SIPs when valuations are high are buying units at high price levels.
"Your holding period must increase for you to achieve decent returns," says Dhawan.
However, as Naren pointed out, many investors may lack the patience to stay invested for extended periods.
Younger investors with long investment horizons may continue their SIPs.
"If your retirement is decades away, continuing SIPs makes sense," says Dhawan.
Short-term investors, who need their money, say, in five years, may struggle to make returns.
Remember that the average holding period for an SIP is not equivalent to the period for which the SIP is run.
"For a five-year SIP, the first instalment runs for five years, but the last runs for only a month. The average holding period is 2.5 years," Dhawan explains.
"At current valuations, investors need at least a 7 to 10-year average holding period to make money in mid- and smallcap funds," says Dhawan.
Markets have begun to correct. While the midcap index is down about 18 per cent from its previous peak, the smallcap index is in bear territory, having declined more than 20 per cent.
If this continues, averaging will happen at increasingly lower levels.
One argument against stopping SIPs is that while selling is easy, getting back into the market is difficult.
"As the market corrects, the commentary turns negative, so investors wait for it to fall even further before they re-enter.
"Then one day a sustained bounce back rally begins. Investors who are out of the market miss it," says Raghaw.
Rebalance equity portfolio
Existing investors should assess their mid- and smallcap exposure.
If their original sub-allocation of, say, 20 per cent to midcap funds and 10 per cent to smallcap funds has grown significantly above those levels, rebalancing must be done.
"Shifting some allocation to largecap funds can help manage risk and enhance portfolio stability," says Shinghal.
The decision to hold on or exit these categories should also depend on the investor's risk tolerance.
"If you can endure volatility and avoid panic selling, stay invested, provided you have a sufficient horizon," says Dhawan.
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Feature Presentation: Ashish Narsale/Rediff.com
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