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Rebuff Mid-Cap Bombast

The new mantra in the markets, for most analysts, revolves around mid-caps. But investors need to ignore that talk as it promotes risky behaviour

On reading and listening to the views of various stock market pundits over the last few days, the one opinion that stands out is that mid-cap stocks are expected to do much better in 2010. The general idea seems to be that the large-cap stocks have done their bit, and now it’s time for mid-caps to march ahead. A favourite phrase seems to be ‘stock-specific’. This sounds like a great story, and for all I know, it may well turn out to be true. However, I also happen to think that most fund investors should ignore it. Here’s why.

For mutual fund investors, the obvious equivalent of an equity investor investing in stocks is to invest in funds that specialise in mid-cap stocks. However, this is a risky business because the penalty for choosing the wrong mid-cap fund is far higher than that of choosing the wrong large-cap fund. When the markets in general fall, large-cap funds that do poorly tend to underperform large-cap indices like the Sensex and the Nifty by a few percentage points. Mid-cap stocks that underperform tend to do so by huge margins. There’s more. When the markets recover, large-cap funds always recover well. However, badly-run mid-cap funds recover poorly and sometimes never recover.

The reason is clear — there’s a lot more variation within mid-cap performances. There are always a large number of mid-caps that are underperforming the general mid-cap, or market trend. Obviously, there are also a good number that are outperforming the trend, but this variability is much higher than that in large-caps.

It is one of the basics of investing in stocks that large companies are fundamentally different than smaller ones. Many of the differences become especially important when there is a decline, either in the general market, or in the specific company that you've invested in. When things turn downwards, smaller companies' share prices decline more than those of large companies. Moreover, smaller companies' shares are less liquid than that of large companies. When you go to sell them, it is entirely possible that there is no one willing to buy, or that they have a high impact cost, meaning that the very act of offering for sale even a modest quantity pushes the price down. Impact cost works in both directions, meaning that it's pretty easy to rig a price upwards and create illusions. Even at the level of fundamentals, there are differences. A far larger proportion of small companies' go into terminal decline, that is, things turn bad for them and they never recover. Because few small companies are being intensively researched bad news can be kept well-hidden far more easily and for far longer.

The question you have to ask is whether your fund manager is up to it. Since optimism is built into the mental make-up of all investors, it’s easy to believe that we’ll all choose the right fund. However, that doesn’t actually happen sometimes. At the end of the day, selecting good mid-caps is a much harder task than selecting good large-caps. It’s more rewarding, but it’s harder.

For all these reasons, I don’t think that it makes sense for fund investors to go chasing after mid-cap specific funds just because such stocks are expected to do well. The relation between some selected mid-caps doing well and mid-cap funds doing well is more tenous than in the case of large-caps. Most well-run large-cap and multi-cap funds have a sprinkling of mid-caps. Unless an investor knows exactly what he’s doing, it’s best to stick to those.