As an investor in mutual funds, you have a wide array to choose from. For example, there are large cap diversified funds, there are multi cap funds, there are mid cap funds and small cap funds. While the cut offs for large cap, mid cap and small cap are clearly defined by SEBI in its latest round of regulations, the multi cap funds are typically formed by a combination of these 3 types of funds. Let us first look at parameters on which you should choose these funds.
Choose large cap versus mid caps versus small cap funds
Between 2015 and 2017, mid cap funds and small cap funds managed to outperform the large cap funds by a margin. However, in the year 2018, small and mid cap funds have been underperformers due to issues like the introduction of the LTCG tax, imposition of additional special margins (ASM) by SEBI and the reclassification of funds by SEBI. It is in this context that the decision between large caps, mid caps and small caps needs to be taken.
- Let us look at the relative merits of these funds in the first place. Mid-caps have been big beneficiaries of cheap oil. This did a world of good for their cost structures and operating margins. Unlike a lot of large cap companies operating in sectors like power, telecom, infrastructure and metals; mid cap companies are not over-leveraged. Hence the level of financial risk is lower. Thirdly, mid caps have consciously stuck to their core competency rather than diversifying into unrelated areas.
- When you craft your financial plan, it is large cap funds that should constitute the bulk of your portfolio. You can have an overall exposure of 15-20% to mid cap funds. Alternatively, you can split the entire portfolio into 50% in large diversified funds and the balance 50% in multi cap funds so as to make the proportionality same.
- Performance is the acid test of any mid-cap or small cap fund. Focus on consistent performance over the last 4-5 years. This is not an assurance of future returns but it is the closest you can get to good performance.
- Benchmarking mid cap funds and small cap funds can be quite a challenge because the indices themselves are quite heterogeneous and hence benchmarking becomes quite a challenge in these cases. It is much easier to benchmark large cap stocks to generic indices like the Nifty and the Sensex.
- Be very clear that you are investing in mid-cap funds purely for the alpha and not for the Beta. Large cap funds can give you beta-plus returns! It is the small cap funds and mid cap funds that will give you alpha. However, in the interests of your long term goals, it is always better to have a larger proportion of your assets in large cap funds.
- When you decide your cap mix among funds, an important consideration is the liquidity ratio. It represents the number of days it will take for the fund manager to wind down the entire portfolio without impacting prices. Diversified large-cap funds have a liquidity ratio of 1.1 to 1.3 days while mid-cap funds have a liquidity ratio of 9-11 days. This ratio can be as bad as 25 days for small cap funds, which is why you must restrict their proportion in your financial plan.
- Stability of the fund management team matters a lot, especially for the mid cap and small cap funds. The consistency of the fund management team is critical in the case of mid cap and small cap funds since consistency of strategy matters a lot. Avoid mid-cap funds where core fund management team has been under constant churn.
- Evaluate mid-cap fund performance in the downturns rather than upturns. That is because, mid-cap funds tend to outperform in a good market but down market presents a clearer picture. Also, in a down market the ability of the fund manager to manage risk is critical as a true test of mid cap funds.
- There is a limit to the quantum of mid-cap and small-cap stocks available in the market. That is why many reputed mid and small cap funds have been restricting fresh sales due to limited opportunities at attractive valuations. When it comes to mid-cap investing opportunities, availability is a major constraint.
Mid-cap funds are a must in every portfolio as an alpha booster. However, the total exposure to mid cap funds and small cap funds must be kept in check so that your long term goals are not compromised.