Are you confused: Large Cap or Mid Cap Funds?

After a period of subdued growth marred by a spate of disruptions, the Indian economy is recovering and has regained the fastest-growing economy tag. However, the growth revival story still carries some chinks in its armor, owing to higher than expected Fiscal deficits, Current account deficit, Inflation or Currency depreciation, etc. This duality of revival and risk had the bearing on the market performance in the last several months, further aggravated by the uncertainty before elections and several unfavorable global factors.

Mid & Small-cap stocks had a phenomenal run during 2014-17 and therefore funds positioning themselves in these categories attracted money at an unprecedented pace. However, 2018 was not so lucky – S&P BSE Mid-Cap – TRI/S&P BSE Small-Cap – TRI have fallen 13.4% and 23.7%, respectively while S&P BSE Large Cap – TRI has delivered almost 2.9% positive return.

Correction in the equity market is part and parcel of your life a few aphorisms like “A rising tide lifts all boat” or “Only when the tide goes out you discover who’s been swimming naked” have taken center stage. What Warren Buffet meant by the latter adage is that when the market is rising, or business conditions, in general, are easy and favorable, most participants look good. But when business conditions worsen and the stock market corrects, it is much easier to see who truly has a good business model.

Caught on the wrong foot

The retail investors who were riding the bandwagon without realizing the imperative risk involved have been caught on the wrong foot. Therefore, it is quite obvious that these naive investors are looking for expert advice.

At the outset, we want to clarify the misconception that Mid-cap & Small-cap stocks are riskier and therefore the funds holding these stocks would also be riskier vis-a-vis Large Cap. Risk is not a function of size but that of its business quality. There are several names like Eicher motors or twins of Bajaj Financial services or IndusInd bank which were small players ten years ago but now have joined the large-cap club. The common mistake people do by interchanging volatility characteristics with risk while explaining the traits of mid & small-cap funds. Volatility is the NAV fluctuation of a fund but it does not distinguish between an upward or downward trajectory of the price movement. So, rather saying that Mid & Small caps are riskier, we should say that they are more volatile animals to tame.

However, the unfettered growth of these Mid-cap & Small-cap funds on the back of strong inflows in recent years may have overshadowed the potential risk to your portfolio. You may be excited looking at the rise in your fund’s NAV over the years but you should not overlook the liquidity risk associated with your fund’s top holdings. If the normal trading volumes in the holding stocks are so thin that AMC has to spend several months to liquidate its holding position without causing any material impact on its share price, your realizable NAV may be impacted severely.

Suppose, your investment manager is facing huge redemption pressure and he is not able to find enough buyers for the stocks he wants to sell to meet the redemption requirements. In that scenario, he will be forced to sell those stocks which he does not want to sell and therefore negatively impacting the interest of leftover investors.

Although Mid/Small-cap mutual funds are more volatile and can be illiquid in certain conditions, they have the potential to generate higher returns for the investors as compared to the large-cap funds in the long term. On the other hand, exposure to large-cap mutual funds provides stability to your portfolio. They are also highly liquid and provide good returns in the long-run. So, the question is not either large-cap or mid/small cap but the prudent strategy of selecting the right combination of these three categories depending on your risk profile.

Now, you may ask this question… what percentage of my portfolio should be in the large-cap?

Before assigning any number, our advice would be to have a good portfolio mix that can provide both stability as well as superior return. Our advice to a medium risk profile investor would be to allocate 40% of his investment towards large-cap equity funds, 35% towards multi-cap equity funds, 15% towards mid-cap equity funds and rest 10% in the small-cap equity.

As per the latest market capitalization ranking published by AMFI, the top 100 companies represent around 69% of the total average market cap, while the NIFTY 50 index represents around 55% of the total average market cap. Hence, a 40% allocation to large-cap mutual funds will represent 34% of the total market capitalization while another 35% towards multi-cap mutual funds will represent another 21% assuming these funds have 55-60% exposure to the large-cap stocks.

There is no defined optimal market cap allocation rule. However, if you are still young in mid – 20’s or early ’30s, having a higher risk appetite, you can allocate more towards mid-cap and small-cap funds. On the other hand, if you are risk-averse, your allocation to the large-cap should be higher than what we have proposed for the above imaginary investor.

Conclusion:

The basic philosophy towards portfolio construction should be to have a higher allocation to large-cap equity mutual funds in your portfolio if you are risk-averse and have a low-risk appetite. On the other hand, if you have a higher risk appetite, longer investment horizon and are willing to ride out the volatility, you should add mid-cap and small-cap equity mutual funds to your portfolio to get relatively higher returns. Rather than trying to predict when the market will be excited about the mid & small cap themes, the prudent portfolio strategy should be to build a mix of different categories of funds in the right proportion, as per your own risk appetite.

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