In the past few months, we have seen investors, especially new investors, simply picking funds in the mid- and small-cap category based on high returns . While we think mid-cap funds should find a place in every long-term portfolio, excessive exposure to this space, especially after a sharp run-up, can be harmful.
In this piece we’ll cover why you need to tread with caution when you go overweight on this market cap segment based on past returns. For this purpose, we will specifically look at the small-cap category, as far as funds go, as this is the segment that has seen the largest increase in investor interest.
Steep valuations
We often ask you to look at long-term returns while picking funds. But then, is that sufficient? If you invested in mid- and small-cap funds based on their stellar 3-year returns, here are some facts you should know: These returns appear superlative as they are point-to-point returns with a base of 3 years ago, when the market was at a low in the pre-election year. This was also a time when mid- and small-cap stocks were really cheap, having very poor fundamentals and bleak earnings growth. Hence, your 3-year returns have a low base that can be deceptive.
Next, look at the price earnings ratio, a key valuation metric used in the stock market to determine a stock’s valuation in relation to its earnings. As can be seen in the table below, from a point three years ago, when large-cap stocks were higher in valuation by a small margin, mid-caps are now at a significant premium compared with large-caps. Such a wide margin often indicates bubble territory.
Now, if you do some simple math on the earnings of the mid-cap category (based on the mid-cap index level and the trailing P/E ratio), you will be surprised to know that earnings fell an absolute 5.5 per cent in the last three years, while the index close to doubled!
| Price earnings ratio | |||||
|---|---|---|---|---|---|
| Now | 3 months ago | 6 months ago | 1 year ago | 3 years ago | |
| Nifty | 23.2 | 21.6 | 20.1 | 23.8 | 18.3 |
| Nifty Midcap | 33.7 | 28.5 | 25.1 | 24.4 | 16.5 |
| As of July 19, 2016 | |||||
Hence, now at a valuation of over 33 times, the earnings growth of companies in the small- and mid-market-cap segment will not find it easy to catch up with the index price run up. Essentially, this is a case of stocks rallying way ahead of the earnings. Over the same period, you will see that large-cap valuations have moved in a more measured way. Recent 3-month and 6-month data shows that large-caps are catching up in terms of returns, without any undue movement in their valuations. And this is with a significant expansion in earnings in the March quarter.
What does this mean for your mutual fund investments? Simply this: Don’t be disenchanted by the poor 1-year returns of the large-cap category, and do not be misled by the higher returns of mid- and small-cap funds over the same period. What needs to be looked at is whether this market cap segment can continue to deliver the same returns at this stage as it did in the past.
| Returns | ||||
|---|---|---|---|---|
| 3 months | 6 months | 1 year | 3 years | |
| Nifty | 8.00% | 15.00% | -1.00% | 12.10% |
| Nifty Midcap 100 | 7.00% | 16.00% | 4.00% | 23.80% |
| Large-cap funds | 8.10% | 16.50% | -0.10% | 15.50% |
| Mid-cap funds | 8.10% | 14.90% | 2.40% | 29.60% |
| Small-cap funds | 9.60% | 17.10% | 7.50% | 36.80% |
| Returns as of July 19, 2016. Returns for funds are category averages. 3-year returns are annualised. | ||||
High standard deviation
Mid- and small-cap funds, as a category, also have high swings in their returns. In other words, their standard deviation is high. We have seen a case of high returns from mid- and small-cap funds. But a high standard deviation means that they can also fall significantly. The numbers below will tell you that the volatility of small-cap funds is twice as much as that of large-cap funds. Hence, while you may be happy seeing high returns in these funds, whether you will be able to take the falls is what will determine whether these funds are really for you.
| Category | Standard deviation |
|---|---|
| Large-cap funds | 19 |
| Mid-cap funds | 31 |
| Small-cap funds | 38 |
| Standard deviation based on daily rolling 1-year returns over the past 3 years. | |
Too swift for comfort
While you may be enamoured by the kind of returns that small-cap funds delivered in the past one year, it is important for you to know about the underlying stocks in these funds. A very direct challenge for fund managers would be to find such winning stocks time and again in this category, given that not many stocks will be fundamentally sound for a fund to pick.
In fact, this is one reason why some fund houses with small-cap funds have actually curtailed investments in their fund by either stopping lump sum investments or limiting them. This itself should give you an indication of the challenges they face in deployment.
There is another real challenge for these funds that arises from illiquidity, especially in small-cap stocks. Due to their illiquidity, these stocks cannot be liquidated by the fund manager in one shot at the appropriate time. Let us take the case of Atul – a stock with a free-float (shares available for being freely traded) market cap of about Rs. 3,100 crore and held by small-cap funds such as DSP BR Micro Cap or Reliance Small Cap (taken for illustrative purposes only).
On an average (in the past 2 weeks), the share’s daily traded volume in the exchange was about 3,370 (quantity). Now, the DSP fund has over 4 lakh shares while the Reliance fund has over 3 lakh shares (not to mention that other funds from the same stable that also take exposure to this stock). Can you imagine how many days it will take for these funds to sell them entirely, when they have to?
Two scenarios can play out: One, if the fund is selling because it has made enough profits, the real profits it will book may be much lower as it will be selling over several weeks to reduce or sell off its position. Two, and more importantly, if the stock turns out to be a wrong pick, or if it is being pulled down due to certain news, the fund will be stuck with the stock as its normal trading volume comes further down, with fewer takers for the shares. This illiquidity risk is what finally shows up in your funds as high volatility or sudden dips in returns.
How to deal with it
This is not to frighten you into not benefitting from the high return potential in this category. All that you need to do is keep your exposure limited, and enter these funds through SIPs.
What if you already hold a chunk of your investment in this category? If you have been holding for long and have very high double-digit returns, you can consider switching some money to a large-cap fund. But if you entered it recently (which is likely as the mid- and small-cap category has seen more inflows from investors in recent times), do not try and exit now as you will incur costs and taxes.
The best you can do to rebalance is to make your future investments, or add more investments now, in large-cap and diversified funds, as this is also a good time to enter the large-cap category given the relatively reasonable valuations. This will also help bring down overall your exposure to mid- and small-caps, and thus reduce the volatility in your portfolio.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.
- Discontinuation of the Systematic Investment Plan (SIP) of the Designated Schemes of MOMF
- Change in Maximum Subscription Amount of Aditya Birla Sun Life Medium Term Plan
Wealth Conversations – December 2024
Are Arbitrage Funds right for you?- Introduction Of Daily, Weekly Frequency In Sip And Changes In Default Sip Date And Minimum Investment Amount For The Groww Mutual Funds
I have recently started SIP in DSP small cap fund for 3 years duration..should I continue?
Hello Sir,
Make sure the fund does not account for over a maximum fifth of your portfolio.
Fantastic analysis of the facts why any sector will work based on the Market Scenario,
Interesting . Comes at a time when mid as well as small caps have done really well, and I was thinking of increasing in my investments in them . Will stay my hands , and perhaps move towards balanced funds ?
Good Article, however Unable to resist temptation as Small investors to see all our investment in Green.
Very interesting. I am planning to have SIP in midcap fund. Seems to rethink. Can I have a good large cap fund and mid cap fund by that I can divide 60:40
Thanks Vidya for this thought provoking article on small and mid funds. A lot of misconception has been clarified here and now I need to revisit my portfolio 🙂
It would be great if you could share your analysis on the International funds.
Hi Vidya, Thanks for posting this article with pricise timing .
Although , it is mandatory for investor to know the pros and cons of every investment being made , with goal and time frame in clear sight .
However, even one looks at the long term return of mid/small cap funds ( 10 years ) , they have given much higher returns in comparision to large cap funds .
I think if goal is far away ( more than 10 years ) , investing in quality mid cap funds wih good past tack record , is a way to go forward .
What do you suggest ?
While it is true that the high returns of small and mid-cap funds are attractive to new investors, it is not necessarily the only reason for the interest shown in these funds. A lot of new investors (read as ‘new to mutual funds’) are likely to already hold most or all of their deposits in bank fixed deposits. This being the case, the risk appetites are fairly high and what better funds to indulge then than mid-small-cap equities. These investors are likely to start off with mid-small-cap equities and move on to large-caps and/or diversified funds next.
I was largely speaking for myself here but I think this will not be a bad generalization too.
Hello Karthik, Thanks for your views. Appreciate it. While you are right in saying that a majority of investors whoa re new to mutual funds would have been invested in FDs, it is precisely the reason why they cannot take risk head on. They are not used to market risks. They are used to a fixed return tht is said upfront. The lure of high midcap returns may be high but the volatility is something that they would not have been familiar with. In our experience, investors who get spooked with falls, especially in midcaps call mutual funds are risky options and exit completely. This happened in the 2008 when retail folios saw a steep fall and it took 6 years for new sets of investors to even come in. Those who make progression from FDs need to take risks slowly, if their intention is to stay with MFs. So it is not just an asset allocation question. It is about ability to take falls.
That has been our experience 🙂 regards, Vidya
Hi Vidya, thanks for the explanation. I do agree with your point that it is very important to be conscious of the high risk that comes with the (generally) high returns of mid and small cap MFs, and that a lot of people who come with only FDs in their portfolio can get lulled into a false sense of security.
Looks like it is a better idea to consider a flexi-cap fund (one that doesn’t have a bias to a particular market-cap), and let the Fund Manager worry about where to deploy money as per their views.
Looks like it is a better idea to consider a flexi-cap fund (one that doesn’t have a bias to a particular market-cap), and let the Fund Manager worry about where to deploy money as per their views.
I have one question:
Lets say I started investing in 1 Mutual with Rs. 5000/month keeping a time horizon of 15 years. But after say 5 years, (my investment becomes 3 Lakh aftre 5 years), I find that the fund is not performing well, e.g. as compare to its peers, or change in Market trends (other category fund performing well ), etc.
Now as a SIP investor what possible approaches, I can take? I am asking this as fund value invested (3 lakh) is pretty high now, so re-investing via SIP will not make sense, and on the other hand if market is high than Lumpsum also will not make sense. Please suggest?
If a fund is not performing well, stop SIPs and start in another fund and hold this for sometime. If the first one continues to underperform, move the entire amount to the new fund. Moving from one equity to another equity fund will not cause timing risks as you are already invested. Also, you should not worry about market condition if you are doing SIP. Thanks, Vidya
Hello Vidya,
As part of smart solutions, for long term investment in childern’s education,the robo-advisor is suggesting Reliance Equity Fund and HDFC TOP 200 as part of portfolio. However, currently, these two are not rated as one of the best options by various other rating agencies. What is your take? Are these funds good to go for long-term investment in education portfolio.
Hi,
I am 29years, new investor into MF. I want to start SIP of Rs. 10000/month for long term (around 10years+ minimum).
I wanted to invest in SBI BlueChip Fund and SBI Small&Mid cap Fund.
1. Are these two good funds to invest?
2. I am thinking of investing in ratio of 50-50% or 60-40% into these funds. It is good decision?
3. Any general comments you want to tell me?
Thanks in advance.
Hi Amit,
Your 10-year plus period is good for equity funds, but remember that you need to always have an asset-allocated portfolio (equity plus debt) to balance out your risks. Note that SBI Small & Midcap fund is a very high-risk fund. For portfolio-specific queries, please use your FundsIndia account to book an appointment with your advisor.
Thanks,
Bhavana
Interesting . Comes at a time when mid as well as small caps have done really well, and I was thinking of increasing in my investments in them . Will stay my hands , and perhaps move towards balanced funds ?
Good Article, however Unable to resist temptation as Small investors to see all our investment in Green.
Thanks Vidya for this thought provoking article on small and mid funds. A lot of misconception has been clarified here and now I need to revisit my portfolio 🙂
It would be great if you could share your analysis on the International funds.
Fantastic analysis of the facts why any sector will work based on the Market Scenario,
Very interesting. I am planning to have SIP in midcap fund. Seems to rethink. Can I have a good large cap fund and mid cap fund by that I can divide 60:40
Hi Vidya, Thanks for posting this article with pricise timing .
Although , it is mandatory for investor to know the pros and cons of every investment being made , with goal and time frame in clear sight .
However, even one looks at the long term return of mid/small cap funds ( 10 years ) , they have given much higher returns in comparision to large cap funds .
I think if goal is far away ( more than 10 years ) , investing in quality mid cap funds wih good past tack record , is a way to go forward .
What do you suggest ?
Hello Vidya,
As part of smart solutions, for long term investment in childern’s education,the robo-advisor is suggesting Reliance Equity Fund and HDFC TOP 200 as part of portfolio. However, currently, these two are not rated as one of the best options by various other rating agencies. What is your take? Are these funds good to go for long-term investment in education portfolio.
I have one question:
Lets say I started investing in 1 Mutual with Rs. 5000/month keeping a time horizon of 15 years. But after say 5 years, (my investment becomes 3 Lakh aftre 5 years), I find that the fund is not performing well, e.g. as compare to its peers, or change in Market trends (other category fund performing well ), etc.
Now as a SIP investor what possible approaches, I can take? I am asking this as fund value invested (3 lakh) is pretty high now, so re-investing via SIP will not make sense, and on the other hand if market is high than Lumpsum also will not make sense. Please suggest?
If a fund is not performing well, stop SIPs and start in another fund and hold this for sometime. If the first one continues to underperform, move the entire amount to the new fund. Moving from one equity to another equity fund will not cause timing risks as you are already invested. Also, you should not worry about market condition if you are doing SIP. Thanks, Vidya
Hi,
I am 29years, new investor into MF. I want to start SIP of Rs. 10000/month for long term (around 10years+ minimum).
I wanted to invest in SBI BlueChip Fund and SBI Small&Mid cap Fund.
1. Are these two good funds to invest?
2. I am thinking of investing in ratio of 50-50% or 60-40% into these funds. It is good decision?
3. Any general comments you want to tell me?
Thanks in advance.
Hi Amit,
Your 10-year plus period is good for equity funds, but remember that you need to always have an asset-allocated portfolio (equity plus debt) to balance out your risks. Note that SBI Small & Midcap fund is a very high-risk fund. For portfolio-specific queries, please use your FundsIndia account to book an appointment with your advisor.
Thanks,
Bhavana
While it is true that the high returns of small and mid-cap funds are attractive to new investors, it is not necessarily the only reason for the interest shown in these funds. A lot of new investors (read as ‘new to mutual funds’) are likely to already hold most or all of their deposits in bank fixed deposits. This being the case, the risk appetites are fairly high and what better funds to indulge then than mid-small-cap equities. These investors are likely to start off with mid-small-cap equities and move on to large-caps and/or diversified funds next.
I was largely speaking for myself here but I think this will not be a bad generalization too.
Hello Karthik, Thanks for your views. Appreciate it. While you are right in saying that a majority of investors whoa re new to mutual funds would have been invested in FDs, it is precisely the reason why they cannot take risk head on. They are not used to market risks. They are used to a fixed return tht is said upfront. The lure of high midcap returns may be high but the volatility is something that they would not have been familiar with. In our experience, investors who get spooked with falls, especially in midcaps call mutual funds are risky options and exit completely. This happened in the 2008 when retail folios saw a steep fall and it took 6 years for new sets of investors to even come in. Those who make progression from FDs need to take risks slowly, if their intention is to stay with MFs. So it is not just an asset allocation question. It is about ability to take falls.
That has been our experience 🙂 regards, Vidya
Hi Vidya, thanks for the explanation. I do agree with your point that it is very important to be conscious of the high risk that comes with the (generally) high returns of mid and small cap MFs, and that a lot of people who come with only FDs in their portfolio can get lulled into a false sense of security.
I have recently started SIP in DSP small cap fund for 3 years duration..should I continue?
Hello Sir,
Make sure the fund does not account for over a maximum fifth of your portfolio.