Are you better off with mid-cap funds over the longer term?

There is value in diversifying your portfolio away from pure large caps to include mid-caps. They have added value in return and risk terms over the longer run.

Sep 09, 2020 02:09 IST India Infoline News Service

In the last few weeks, we saw mid caps and small caps getting the better of large cap stocks in the markets. How have large and smaller cap indicesperformed since Jan-20?

Data Source: NSE

Nifty has given (-6.97%) returns on YTD basis but the mid cap and the small cap indices are in the positive. YTD returns may not capture the picture ofmarket volatility, so one can look at these indices in terms of returns from the lows of March. The Nifty has bounced 48.9% from the lows of Mar-20 but the mid cap and small cap indices have bounced 55% and 65% respectively from the lows. Clearly, there is a story building up. That brings us to the basic question; do mid cap and small cap funds add more value than large cap funds?

How do the top performers compare in terms of returns?

Let us look at these 3 categories of funds from a 5-year return perspective and see how the top-3 performers (Direct Plans) have done.

LARGE CAP FUNDS
Fund Name 1-Year Returns 3-Year Returns 5-Year Returns
Axis Blue Chip Fund (G) 9.141% 10.609% 12.694%
Canara Robeco Blue Chip (G) 10.601% 9.493% 12.065%
Mirae Asset Large Cap (G) 7.882% 5.984% 11.904%
MID CAP FUNDS
Fund Name 1-Year Returns 3-Year Returns 5-Year Returns
DSP Mid Cap Fund (G) 20.862% 6.023% 12.410%
Axis Mid Cap Fund (G) 19.602% 12.007% 11.877%
INVESCO India Mid Cap Fund (G) 19.161% 7.354% 11.511%
SMALL CAP FUNDS
Fund Name 1-Year Returns 3-Year Returns 5-Year Returns
SBI Small Cap Fund (G) 20.957% 8.332% 15.048%
Axis Small Cap Fund (G) 14.599% 9.699% 12.797%
Nippon India Small Cap Fund (G) 19.756% 2.725% 12.663%
Data Source: Morningstar

Two things emerge from the limited data. Firstly, mid cap and small cap funds are better at catching short term volatility returns compared to large cap funds. Secondly, over a five year period, large caps and mid caps have done almost at par, as have small caps, if you exclude the outliers. Let us look at an overall category level over last 10 years.

Fund Category Average 10-Y returns Top Performer Worst Performer
Large Cap Funds 8.21% 12.43% 3.61%
Mid Cap Funds 10.98% 13.21% 8.02%
Small Cap Funds 10.01% 17.52% 5.02%
Data Source: Morningstar

As a category, if you want to ignore the fund selection risk, mid cap funds have given the best average returns. Also the variation between the top and bottom performer is much lower in the case of mid-cap funds making them more reliable and predictable. As a diversifier of performance and return booster, mid cap funds surely have a case. What about risk reduction?

How do the funds stack up on the risk barometer?

We shall look at risk in multiple ways and how large cap funds, mid cap funds and small cap funds stack up on this parameter.

Fund Description 1-Year 3-Years 5-Years 10 Years
STANDARD DEVIATION
Large Cap Funds 31.046 21.257 19.098 17.366
Mid Cap Funds 34.252 23.478 20.859 19.796
Small Cap Funds 40.198 28.109 24.166 21.968
R-SQUARED (CORRELATION SQUARED)
Large Cap Funds 92.178 87.573 88.766 92.151
Mid Cap Funds 95.981 92.857 91.217 89.871
Small Cap Funds 96.404 93.641 90.945 80.568
ALPHA (EXCESS RETURNS)
Large Cap Funds 1.659 -0.665 -0.531 -0.449
Mid Cap Funds 0.846 1.411 -0.780 2.873
Small Cap Funds -5.473 -1.259 0.029 4.118
Data Source: Morningstar

Three things can be deduced from the table above.

a) In all the three categories of funds, there was a clear reduction in risk as the holding period was extended. However, small cap funds appear to carry a large volatility risk in the short term.

b) R-Squared can be used to understand how much of the returns are explained by the index. In the case of large cap funds, the R-squared is the same over 1 year and 10 years. There is no great benefit on that front beyond what you get on an index fund.

c) Over the longer period, if you look at alpha to capture how much excess returns the funds give over the return expectation, mid cap funds are adding value to your portfolio, in terms of risk and returns.

Portfolio allocation – How do we interpret the results?

There is value in diversifying your portfolio away from pure large caps to include mid-caps. They have added value in return and risk terms over the longer run. Small cap funds, in contrast, have been too volatile and slightly harder to predict. Also, as we have seen in the recent past, small cap funds tend to restrict fresh flows if opportunities are not available in the market or if valuations are steep. That could be a hitch.

The bottom-line is that for portfolio diversification and for return enhancement, investors can look at adding mid cap funds to the portfolio, although it can be limited to a certain portion of the portfolio only. Small cap funds may not add too much value per se.

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