Mutual funds focussed on investing in mid- and small-cap stocks are raking it in.

With small-cap funds averaging returns of 37 per cent in 2016-17, their assets under management (AUMs) surged over 70 per cent in this period, according to latest data.

Mid/small-caps sprint

While the bellwether BSE Sensex managed to move up 17 per cent in 2016-17, the BSE SmallCap Index and MidCap index sprinted by 35-36 per cent. With mid- and small-cap stocks being market favourites since the 2014 rally, the asset base of many funds, which invest in these stocks, has increased manifold in the last three years (see table).

Small-cap focussed funds such as DSP BR Micro-Cap and Franklin India Smaller Companies saw their asset size double in the last one year.

Red flag

But there is the downside to this story: lower liquidity in mid- and small-caps often becomes an impediment to buying/selling the desired number of stocks at a desired price.

Thus, DSP BR Micro first suspended new subscriptions/switch-ins over ₹1 lakh in August 2016,and from February 2017, stopped them altogether.

Mirae Emerging Bluechip, which invests in mid- and small-cap stocks, suspended fresh lumpsum subscriptions/switch-ins since October 2016. Canara Robeco Emerging Equities fund recently changed its fundamental attributes to ‘Mid-cap equity instruments’ from ‘Mid-cap and small-cap equity instruments’.

Apart from the size, after a rally extending three-four years, valuations have become a concern too. The BSE SmallCap Index and the BSE MidCap Index now trade at 69.8 times and 32.2 times their trailing earnings, respectively, compared with the Sensex’s 22.4 times.

But fund houses believe that the sudden spate of heavy inflows is more the cause for worry than high valuations. Explains Ravi Gopalakrishnan, Head–Equity, Canara Robeco Mutual Fund, “We follow more of a bottom-up approach in choosing stocks for the Emerging Equities fund. I wouldn’t say we changed the mandate because of high valuations.

“As the market rallied and market-cap of stocks expanded, many of the mid-caps became large-caps, shrinking our investible universe. Also,with the increase in fund size, we needed more liquid names so that there is minimum impact cost during buying and selling.”

Swarup Mohanty, CEO, Mirae Asset Mutual Fund, too echoes a similar opinion. “Although high valuation is a story that is running alongside, fund managers have managed that expectation well. When there is abnormal inflows, we have a primary responsibility to safeguard the interest of existing investors.”

It’s a tightrope walk for funds managing the inflows, the valuations and the stock liquidity issue.