What are Mid-Cap Equity Funds?

Mid cap funds are all the rage this season. How do we define mid-caps in the first place? As per the latest SEBI definition, stocks listed on stock exchanges are first classified based on their market capitalisation. Stocks from position number 1 to 100 on market capitalization are large cap stocks. They typically have a market cap above Rs.30,000 crore.

Stocks from 101 to 250 are mid-cap stocks. Their market typically ranges from Rs.10,000 crore to Rs.30,000 crore and below that are the small cap stocks.

BUT, WHAT EXACTLY ARE MID-CAP FUNDS?

Mid cap funds are a corollary to your understanding of the idea of mid cap stocks. Mid-cap mutual funds are equity mutual funds that invest your money in mid-cap companies. These funds invest anywhere between 65% to 95% of their portfolio in such mid-cap companies, although as per the new SEBI rules, mid-cap companies must have at least 75% in mid-cap stocks. These funds generally track benchmarks like BSE Mid-Cap Index and try to get better returns on their funds.

WHY HAVE MID-CAP FUNDS DONE BETTER THAN LARGE CAPS?

Mid cap stocks outperformed large cap stocks by a margin in most years and even on a long term period basis. Even in down markets, the mid-caps have not grossly underperformed the large cap stocks as used to be the case in the past. Mid cap funds bring some distinct advantages.

• Mid-caps have been big beneficiaries of dividends of cheap oil. This has done a world of good for their cost structures and their operating margins.
• Secondly, unlike large cap companies in sectors like power, telecom, infrastructure and metals; the mid cap companies are not over-leveraged. Financial risk is lower.
• Thirdly, mid-caps have stuck to their core competency rather than trying to diversify into unrelated areas. This has helped manage the business cycles more effectively.

DO YOU HAVE A CHECK LIST BEFORE SELECTING A MID-CAP FUND?

There are a number of parameters to consider while selecting a mid-cap fund. Here is a quick checklist.

• Look at the performance the mid-cap fund over last 4-5 years. This is not an assurance of future performance but this is the closest you can get. Unlike large cap stocks, mid-caps are extremely heterogeneous. When a mid-cap fund outperforms consistently, it is a statement on their mid-cap stock selection skills. Consistent performance over a period of 4 to 5 years is a good indication of good stock selection skills by the fund manager.
• When you invest in mid-cap funds your goal is not getting beta-plus returns. Your goal is alpha or substantial outperformance. Therefore, what is important is your proportionate exposure to these mid-cap funds. Ideally, you need to ensure that once the good funds are selected, you restrict your overall exposure to these mid-cap to around 15-20% of your overall equity mutual funds portfolio.
• Check out the CRISIL liquidity score for mid-cap funds, that is extremely important. What exactly is Liquidity Ratio for mid-cap funds? It represents the number of days it takes for the fund manager to wind down the entire portfolio without negatively impacting prices. While large-cap funds have a liquidity ratio of 1.1 to 1.3 days, mid-cap funds have a liquidity ratio of 9-11 days. This gives an idea of liquidity risk.
• Stability of the fund management team and investing strategy is the key to mid-caps since it is largely a bottom up approach to investing. Investing in mid-cap funds is an art that is perfected over a period of time. Hence the consistency of the fund management team is critical. Avoid mid-cap funds if the core fund management team has been going through churn. That is not a good signal.
• The bottom line is risk adjusted returns. It is easy to add returns by adding risk but that can badly backfire. Hence risk-adjusted measures like Sharpe Ratio and Treynor ratio become important. You do not want a fund manager who is giving more returns purely by assuming more risk. The fund manager is actually playing ducks and drakes with your money.
• Focus on mid-cap fund performance in downturns rather than upturns. That shows the character of mid-cap funds. A down market presents a clearer picture of the ability of the fund manager to handle risk. It is in the downturn that you get the best opportunities to pick stocks at salivating levels.
• Availability is a big risk in mid-caps, even today. We have seen in the past that several mid cap funds had to restrict fresh sales on the fund due to limited opportunities to invest in mid-cap stocks at attractive valuations. This can be an irritant and a constraint.

The moral of the story is that mid-cap funds are a must in every portfolio for that much-needed alpha boost to your portfolio. A clear understanding of pre-conditions of buying mid-cap funds will be of help to you.

IS IT TRUE THAT THE CHOICE OF MID CAP STOCKS IS LIMITED FOR MID-CAP FUNDS?

 

Unfortunately, that is still a major risk that most mid cap funds run in India. There is an absolute shortage of mid cap ideas in the market that fund managers can bet on. Also, there are fewer sell side analysts tracking such mid cap ideas with solid research. When flows into mid cap funds start burgeoning, fund managers are in a dilemma.

They normally have two options. They can either dilute the focus by getting into slightly larger cap stocks or they are compelled to go down the quality curve. That means they must pick companies that are of lower quality and more speculative in nature. That is surely not a comfortable situation to have in a mid-cap fund.

ARE MID CAP FUNDS HARDER TO BENCHMARK THAN LARGE CAP FUNDS?

Unlike large cap stocks, these mid-caps are more heterogenous. This makes them harder to benchmark. This is a unique problem specific to mid-caps and mid cap funds. The large cap fund can be benchmarked to Sensex or Nifty because they represent the largest stocks in the market in terms of market capitalization.

However, the mid-cap index, by itself, can prove to be a misnomer. Mid-caps are so heterogeneous that it becomes hard to club them under a single category and create an index out of it. Even when the index is created, it actually represents nothing except a bunch of companies trading in a similar market cap range with little similarity otherwise.

Mid-caps funds are a great idea in a growing economy like India as they typically represent the spirit of enterprise in India. However, as an investor in mid cap funds, you need to be conscious of the risks involved and your allocation.