SEBI’s Alert: Froth Warning and its Impact on Mid and Small-Cap Funds

Posted By: Blog

Lately, the mutual fund industry has been buzzing with news about the small and mid-cap segments. There have been reports suggesting the presence of froth in these segments. Additionally, the Sebi chairperson has expressed the desire for all mutual fund houses to conduct stress tests. What exactly is froth? And what are stress tests we'll delve into these topics shortly.

What have the Small and Mid-Cap Funds done in the past?

Let's start by examining how the small and mid-cap segments have fared in the last few years. Investors who have put their money into small or mid-cap funds, either through a lump sum investment three years ago or through SIPs over the past three years, would have enjoyed impressive double-digit returns. Small caps have delivered returns in the range of 20s to 30s.

Mid-cap stocks have shown impressive growth, ranging from 18 to 25 or even 30%. Investors have experienced substantial returns as a result of this. Some small-cap funds have even doubled in value over the past 2.5 years. While they have been great assets for investors, small caps tend to have low trading volumes.

Floating Volume

Have you ever heard the term "floating volume"? It refers to the market capitalization of small-cap companies, which is often less than 10,000 crores. This means these companies can face liquidity challenges. Open-ended mutual funds, on the other hand, aim to be able to honor investor redemption requests within just 2 days.

Scenarios of Investors Investing in Small and Mid-cap Funds

The question is whether these small-caps have the liquidity to sell in the market, generate cash, and provide the money to the investor within two working days. This is what the Securities Chairperson wants to know. If you're an investor who has put money into these small and mid-caps, three possible scenarios may unfold in the coming months.

Scenario: 01 Some Amount of Value Correction Happens

The value can be adjusted slightly, maybe by 10% or even 20%. Over the past three years, you have gained 100% value. A 20% correction is not necessarily negative. It helps to consolidate the market segment, which is beneficial for long-term market growth. Therefore, you can anticipate a consolidation and a correction of around 10 to 20% in terms of value.

Scenario: 02 Expect Increase in Small Cap SIP 

The interest and SIP inflow into Smallcaps could sustain the upward momentum. The equity markets and mutual fund space have a significant amount of liquidity, attracting small investors who want to achieve returns. This trend is unlikely to end abruptly, resulting in improved returns.

Scenario:03 Valuation Of Small Cap will not change

With new money entering the market, profit booking happening, and small-cap funds holding steady, the valuation could remain unchanged. This period of stability is referred to as a time correction, indicating that the value will stay constant for the next two years. Three potential scenarios to keep in mind.

Check out the video link for a more in-depth understanding 

What should one do as an investor in Small and Mid-Cap Funds?

As an investor, I am frequently approached with the question of what steps I should be taking based on these scenarios. It's a common query that I encounter, and it's crucial to make informed decisions.

Exit Small and Mid-cap if need money in 18 months

If you find yourself in need of funds that are currently invested in small and mid-cap stocks within the next 18 months, it would be wise to withdraw the necessary amount. It's best to keep that portion of your investment away from the small and mid-cap sectors for now.

If you have a longer time, 5 years or more - Stay invested

Let's talk about long-term goals. Imagine you're dreaming of retiring in ten, fifteen, or even twenty years. Well, here's a little secret: don't sweat it. Instead, embrace the present, go with the flow, and become the ultimate surf rider. Just like when you catch a wave, ride it as it goes down, and when it bounces back up, you'll bounce back too. The market's fluctuations are beyond your control, so why stress about it? Your investment horizon is long-term - think five years, seven years, or even further down the line. Just relax, stay invested, and keep up with your SIPs.

If your goal is to make a profit, just book the profit leave the principal, and stay invested

If you happen to fall into the third scenario where your investment goal is to book profits, I strongly recommend taking your profits today and keeping the principal amount invested in the fund. It's crucial for all investors to carefully assess their portfolios of small and mid-cap investments and determine the necessary actions to be taken.

What does Froth mean?

South Indian filter coffee is traditionally served in a tumbler and davara. To enhance the flavor, it is customary to toss the coffee in the air, allowing it to cool down and mix. After this process, you may notice a slight increase in volume in the tumbler, but it is not liquid. It is a mixture of semi-liquid and semi-gas, known as froth. However, this froth has no value and will vanish quickly. If you let the drink cool, the froth will disappear completely.

It is believed that the same situation may occur in the small-cap market. Many small-cap stocks have exceeded their true value. Therefore, the solution is to reduce involvement in that specific market segment and allow it to stabilize, so that the prices become more reasonable. This process does not occur on its own. One must actively contribute to it. With time, this adjustment will hopefully occur throughout the entire market.

Check out the video link for a more in-depth understanding 

What is a Stress Test?

Stress occurs when we engage in activities that go against our desires. As humans, we experience stress when we are required to do something that we are not naturally inclined to do. This is particularly evident in the investment world, specifically with Smallcaps, when attempting to sell off a portfolio. The duration it takes to successfully sell off the portfolio is known as a stress test.

Small-cap and mid-cap investors should prioritize stress tests as they determine the liquidity of their portfolios. It's essential to understand that investing is not the sole focus. The real challenge lies in retrieving your money, which is when the transaction concludes. Investing is only the initial phase, while the stress test plays a significant role during the money withdrawal stage.

Larger funds, such as Nippon or SBI, face a challenge when it comes to liquidating 50% of their portfolio within 30 days. This means that if all investors decide to redeem their portfolio on the same day, the fund will need 30 days to return their money.

The purpose of the stress test is to highlight the illiquidity of Smallcaps, despite their high returns. It is essential for us, as investors, to grasp this concept. Sebi will use this data to develop protective measures for small investors. We are eagerly anticipating their findings.

We need to understand that Mid and Smallcaps are likely to be volatile soon until SEBI establishes an order format.  So if there is some money that you want to take off the table at this point may not be a bad idea.

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