Equity Mutual Funds: Are you investing for capital growth or downside protection?

Most investors are lured to equity investing with a dream of making exponential returns. A lot of investors have burnt their hands investing in direct equity and lot of them have moved to a safer option of equity investing through Mutual Funds. Due to the bull run after Covid 2020, mutual funds have also offered great returns to investors, be it sector funds, flexicaps, midcaps or smallcaps. Due to this SIP numbers are at record levels.

Most investors look at historical returns of mutual funds or indexes and would like to invest in the highest performing ones. Investors who do a little more research before investing, quickly come across lot of articles or advise from advisors, friends and family that this fund performs great, but what happens when the market goes down? How much downside protection does the fund provide? Especially the narrative around midcaps and smallcaps is that they give returns when markets perform well, but really crash in a market downturn. Hence a lot investors then tend to choose a fund that does not fall down as much in a recessionary market.

Let us compare a real life case of two funds and try and understand this. Parag Parikh flexi cap fund provides one of the best downside protection in bad markets hence I will take this fund and compare it with Nippon smallcap fund, because smallcaps are expected to do worse during a downfall.

From Oct 1 2024 to March 15 2025, Parag Parikh flexi has fallen down only by ~6.5% and in the same period Nippon India smallcap has fallen by 22%. So anybody who would have invested on 1st October 2024 was much better off investing in Parag Parikh flexi cap. However, investment in equity funds is suggested only with a minimum 3 to 5 year horizon and in smallcap funds with a 5 to 7 year horizon. Let us look at investment value in both the funds with 3 to 10 year investment horizon.

Here we can clearly see, that in spite the recent 6 month significant underperformance, as on 21-03-2025 corpus of Nippon smallcap would have been higher if investment was made 3 to 10 years ago. This is because during the time of positive returns, Nippon smallcap has surged much ahead. Even if we look at data if SIP was done over a 3 year period Parag Parikh was having a larger corpus; but over a 4 to 10 year horizon Nippon smallcap surges ahead.

Since January 2015 Nifty has ended in the green 1,355 times and in the red 1,155 times and has surged from 8,284 on Jan 1, 2015 to 23,190 on March 20, 2025. The overall premise be it India or any other economy is that equity markets would grow in the long run despite short term disruptions caused by events such as elections, war, tariffs, economic slowdowns, etc. Considering this, should we be investing for the long term growth prospect of fear of the drawdowns caused by short term events?

The purpose here was not to compare the two specific funds or compare flexicap vs. smallcap but to see the actual long term results after the recent fall. Whatever goes up more is likely to come down more as well. The purpose is also not to suggest investing in funds with a high beta, but before investing do not just look at the downside in short periods.

If you are an investor that are investing for the long run but may need capital in between then yes funds with better downside protection are required. But if you are an investor for the long run and can also tolerate short term dips, you essentially need to decide if you would like funds which provide more growth overall or funds that have better downside protection in a recession.