Portfolio managers are pruning allocation to mid and small cap funds by 5% in investor portfolios. This comes amidst fears of the second wave of Covid -19 hurting economic growth, high valuations and a sharp run up over the last one year.“Indian mid and small-cap stocks have traded at lofty P/Es. The current valuations indicate a premium to our fair value assumption. Aggressive investors can reduce mid and small cap allocations by 4-5% from their targeted allocations. In our aggressively managed portfolios we have reduced midcap allocation from 13% to 10% and small cap from 7% to 6%, ” says Dhaval Kapadia, CFA, Portfolio Specialist, Morningstar Advisers.Investors have made high returns from this category of funds over the last one year. Small cap funds have returned an average of 92% over the last one year with few funds returning more than 100%. The midcap fund category too has returned 69% in the same period.Kapadia believes the recent sharp surge in COVID-19 infections across the country and consequent restrictions will threaten to disrupt the recovery momentum and would weigh on GDP growth. In the coming months, effective control of the fast-mutating virus spread, and the pace and efficiency of vaccination drives would determine the level of economic activity in the months to come. Analysts believe the economy faces a risk of slowdown and corporates will face a difficult quarter with states imposing restrictions and partial lockdowns, directly impacting consumption demand, logistics & transportation, and manufacturing activity.Analysts point out that midcaps and small caps trade at a premium to large caps. While The Nifty 50 trades at a PE of 32, the Nifty Midcap 150 trades at a PE of 40.95. Over the last one year the Nifty 150 Midcap Index PE has doubled from 21.62 to 40.95, while the Nifty Smallcap 50 PE has moved up from 14.98 to 82.79 in the same period.“Several mid and small cap companies are trading far ahead of their earnings. With the second wave of Covid 19 the kind of sharp economic revival we were expecting is in jeopardy,” says Harshvardhan Roongta, CFP, Roongta Securities. Roongta believes investors whose mid and small cap allocation has risen should bring it down to 30%.