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Why mid and smallcaps are needed in portfolios

Radhika Gupta, MD & CEO, Edelweiss MF, says “we are telling people, do not switch your existing mid and smallcap fund holdings and pay a lot of tax, but at least put incremental money in multi-cap funds. Could a behaviour of this kind happen? Yes. So that could lead to a moderating of flows by 10-20%? Yes, absolutely. And if it does, I do not think we should be very upset because the money will go somewhere else. It will go into a hybrid fund or a multi-cap fund.”

I saw your data point from Edelweiss Mutual Fund. It’s pretty interesting, 50% of your portfolio can be liquidated in three days flat or is it six days? But single digit, right?
Radhika Gupta: Yes, for smallcap, it is three days; for midcap, it is two days, 25% can be in one-two days. People have been commenting over the weekend that this is surprising. To be frank for us, this was not a surprise because well before Sebi started having conversations about this, we have been hawks about liquidity in our portfolio and I am so glad that it is becoming public conversation.

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Liquidity statistics are something we monitor in our monthly investment reviews. It is stuff that we disclose to our board in a risk meeting and it is stuff that we put in our presentations. In fact, the Sebi liquidity statistics still are a little bit generous because they give you that 20% carve out for most liquid securities. We disclose those statistics without that carve out. For us, liquidity has been a very important part of managing mid and smallcap funds and we have always prided ourselves on holding very liquid portfolios.

The other thing with our disclosures is if you look at our disclosures, we do not hold cash in our funds. So, cash percentage maybe 1-2%. We do not hold largecap in the smallcap fund. So, we built liquidity into the portfolio when we are making stock selection decisions rather than saying, chalo 10% cash dal dete hai, 5% largecap dal deta hai (let’s keep 10% in cash and 5% in largecaps) to maintain liquidity. I am very happy that it is becoming part of public conversation.

The nature of conversation has also changed about midcap and smallcaps. A lot of stuff is being discussed. Some say it is a very risky area, one should not be there, you have to get in and get out. The other side of the equation is people saying that with the breadth of growth which India is witnessing, midcaps and smallcaps have to be some part of your portfolio and you have to play them via diversified basket over 5-10 years. Is this view justified?
Radhika Gupta: My thoughts are there has to be a middle path and the reason the problems and conversation has shifted in the direction it is, is because we have moved away from the middle path. Fundamentally, I do believe that if you look at midcaps and smallcaps, firstly India has a very unique way to classify a company as midcap and smallcap. It is a rank-based definition, so midcap is 100 to 250 and smallcap is 250 and beyond.

If you look at the average size of a midcap in the country today, it is Rs 35,000 to 40,000 crore. These are not mid-sized companies. In fact, in most segments outside of maybe banking, tech and energy, if you want a market leader in any industry, it is in the midcap index. So, fundamentally, do I believe that portfolios need to have mid and smallcap to capture the breadth of the decadal India opportunity? Absolutely, because if you want a leader in capital goods or capital markets or diagnostics or China plus one or chemicals, these are all mid and smallcap companies.

I do not think a largecap portfolio in its sense is complete. I believe that thesis. The problem is that people have forgotten asset allocation. If you look at portfolios today, they are skewed 70-80% towards midcaps. The other problem is, and I was shooting yesterday on Shark Tank; people who are clearly not very smart or not very aware of investing, if you ask them what they had invested in, their first investment was a smallcap fund and only a smallcap fund. Now, this to me is a little bit of a scary signal. People are looking at last one-year’s returns.

People are looking at last 18-month returns and just buying mid and smallcap funds and the regulator is concerned and they have a right to be concerned because when this unwinds, this unwinds very badly. You have already started seeing that noise with just a minor 10% correction. To me, for an investor, the middle path is that you hold midcap and smallcap in some proportion, 20%, 30%, 40%; you hold it via flexi-cap fund, you hold it via multi-cap fund and the one thing that this liquidity conversation in my view has done is nobody is saying that even though my fund house looks very good, go rank fund houses on liquidity parameters only and invest. But nobody is saying that.

What I am saying is do not just use return as the only metric to decide where you are going to invest, that too last one-year’s return; also think about liquidity. It is moving us to the middle path.

Surely moving to the middle path is what you are saying, not only returns, but liquidity has come into the conversation now. But in the near term, does that mean finding this middle path, maybe we will see more controlled flows coming in the mid and smallcap side? If everyone is realising how to allocate your funds, then for these mid and smallcap schemes maybe a bit more controlled flows is something that we could see?
Radhika Gupta: You could. Look, a part of the mid and smallcap flows come via SIP. If we look at our SIP books, they are very mid and smallcap heavy. So, I do not think you are suddenly going to see SIPs into mid and smallcap funds stopping. Retail flows do not vanish overnight. But could flows temper down by 10-20%? Fresh flows could. Could existing investors who have money in mid and smallcap funds perhaps say, okay, I am going to switch them to flexi-cap or multi-cap funds or could incremental allocations happen in multi-cap funds? We are recommending the third.

So, we are telling people, do not switch your existing mid and smallcap fund holdings and pay a lot of tax, but at least put incremental money in multi-cap funds. Could a behaviour of this kind happen? Yes. So that could lead to a moderating of flows by 10-20%? Yes, absolutely. And if it does, I do not think we should be very upset because the money will go somewhere else. It will go into a hybrid fund or a multi-cap fund. Finally, the industry should focus on investor experience and investors coming in, making money not in NAV terms, but in their own growth and being long-term investors. So, it could happen.

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