Mutual funds: What should you do with underperforming mid-cap, small-cap funds?

The equity markets have not performed well so far this year. While large-cap stocks have given marginal returns, small and mid-cap stocks are battered. Looking at the returns of mutual funds, the category of large cap funds has barely managed to stay afloat with around one per cent return (as on September 12) while the categories of mid-cap and small-cap funds are down six per cent and seven per cent, respectively, as per the data available on Value Researchonline.com.

With the steep correction in the mid-cap and small-cap funds, many investors now wonder if this is a good time to invest in them, while those already invested wonder if they should exit and move their investments in large-cap funds.

Such situations occur multiple times in an investor’s investment journey. Let’s understand return differential across fund categories over the long-term and how to decide how much to allocate funds across different asset classes.

Defining the capitalisation

In order to make the comparison easy, Securities and Exchange Board of India (Sebi) has clearly defined different categories of funds. Large cap fund will invest at least 80 per cent of their assets in large cap stocks while mid and small-cap stocks will invest at least 65 per cent in mid and small cap stocks. Large-cap stocks are the top 100 stocks on the exchange as per the market capitalisation, while mid-caps are the next 150 stocks ranging between 101 and 250. Stocks beyond 251 are defined as small caps. Multi-cap funds can invest across categories and the allocation is left to the discretion of the fund manager.

Large cap stocks are well-established companies and show more resilience towards different economic cycles. “Placing your money in large-cap stocks means lower risk. It helps you fetch stable returns as these companies show lesser volatility in earnings, hence lesser volatility in stock prices. The predictability of earnings from these companies is normally good and the management has a track record of performance and corporate governance practices,” says Ankita Narsey, founder, Oaktree Financial Services.

While mid and small-cap stocks respond faster to different economic cycles due to their smaller size, similar tendency is reflected in stocks of these companies. They rise faster than their larger counterparts and at the same time are hit harder during market downturns.

In 2017, when markets went up, mid and small-cap funds delivered 44 ad 55 per cent returns, respectively while large cap funds were up only 31 per cent.

What happens in the long run?

Historical data suggests small-cap and mid-cap funds outperform large-cap funds on most occasions over the long-term, but the differential may not be huge given the volatility. “In the long run small caps tend to outperform midcap and large caps. However, if allocations are manoeuvred in a thoughtful manner, the differential could be huge, otherwise return differentials do not vary much even for a period as long as 10 years. Our experience says different market cap segments and index returns tend to converge in the long run,” says George Heber Joseph, CEO & CIO, ITI Mutual Fund.

If you look at the graph, it shows 10-year annualised category average return on a daily basis in different fund categories over the last five years. In most occasions, mid and small-cap funds have done better than large cap funds or even multi-caps. The average 10-year return of a large cap fund category over this period was 12 per cent. The maximum 10-year return (an average large cap) delivered was 18 per cent while minimum was around six per cent. The average return for a mid-cap category stood at 15 per cent and maximum and minimum return was 23 per cent and 10 per cent, respectively. At the same time, small-cap category average was 15 per cent and maximum and minimum 10-year annualised return by the category was 22 per cent and 11 per cent, respectively.

However, the category of multi cap fund, which can invest across stocks irrespective of the market capitalisation, delivered an average return of 17 per cent while the maximum return was 26 per cent and minimum was nine per cent.

What should you do?

You should decide the capitalistion mix of your portfolio based on your risk appetite. If you have the risk appetite for mid and small-cap funds but are not able to decide the asset allocation mix and you don’t have access to good advice, you better invest in multi-cap funds. They are likely to deliver better than large-cap funds and will be less volatile than mid and small-cap funds. The biggest advantage is that the fund manager will take the call on how much money should be allocated on your behalf across market capitalisation categories. “In multi-cap funds, fund managers help investor take right set of weightages across stocks at different points of time as per market valuations,” says George Heber Joseph, CEO & CIO, ITI Mutual Fund.