VR Logo

Taming the Mid-Cap Beast

Mid and small-cap funds will always be volatile, but understanding and using this volatility can bring great benefit...

Now that there’s a small wind of optimism blowing through the equity markets, its time for many mutual fund investors to take a fresh look at their portfolios and see if its distribution among different kinds of funds is the optimum one going forward. For seasoned investor at least, one vexing question always has been the exact role that funds that focus on mid-cap and smaller companies should play in their investment strategy.

Depending on their personal investing experience, that is, when they were invested in mid and small cap funds and when they were not, investors are divided between two sharply opposed opinions on such funds. There are those who think that mid and small cap funds are great for getting ahead of the markets’ more popular large-cap end; and there are those who think that investing at the smaller end is an invitation to disaster.

Both views are correct, after their own fashion. Since 2003, when last decades’ great bull run properly got going, mid-caps have repeatedly run ahead of large caps and then fell back sharply. An exact comparison of the progress of the BSE Sensex and the BSE Midcap tells the story rather nicely. At the beginning of April 2003, the Sensex was 3081 and the Midcap Index was 900. To make the comparison simpler, let’s equalise this point to 3081 on both. In May 2006, after three years, the Sensex hit a peak of 12,612. At that time, the Midcap index was already at an equivalent level of 20,671 having run ahead of the large-cap index by an amazing 64 per cent.

For investors who had discovered the joy and excitement of investing in smaller companies, the next month was a pretty hard landing. The Sensex fell almost 30 per cent but the Midcap index fell 40 per cent. However, the markets turned and the journey back started once more with the same pattern as earlier. In January 2008, when the Sensex peaked at close to 21,000, the Midcap index was at an equivalent level of 33,600. Predictably, the landing was even harder. By the end of March 2009, the Sensex was at 10,000 the Midcap index was just below that level having given up all the margin (79 per cent at its peak) by which it had overtaken the large-cap bellwether.

In the years since, even though the magnitude of the bull-runs’ wild ride has not been matched, the pattern remains the same. However, the moral of the story is not to avoid mid- and small-cap investing, but instead, to do it in a way that this pattern can be exploited to yield higher returns. And first step in doing so is to appreciate the fact that the variance in mid-cap stock performance is so high that it offers the better fund managers a wide scope for beating the markets. Moreover, the underlying volatility, when it appears in a well-run fund, actually serves to enhance returns from SIP investments.

Here are some fascinating numbers that demonstrate this. In the period since March 2009 low mentioned above, an SIP in a Sensex or a Nifty tracking fund would have yielded a rather pedestrian return of a little over 5 per cent. Over this same period, the median mid and small cap fund in Value Research’s database has yielded a return of 14.8 per cent p.a. That’s just the median fund and I’m quoting its numbers first to show that that’s what a middle-of-the-road mid-cap fund did. The 25th percentile fund did 17.4 per cent and the best 28.7 per cent. No great fund picking skills were needed to get these bonanzas—about 40 of the 50-odd funds beat the bellwether indices by huge margins.

But as we saw above, that’s just one side of it. The volatility in mid-caps is always there and it can turn negative with very little notice. When the markets fall, these funds will fall more. Therefore, they are suitable only for those who can deal with this. For the less-involved investor, a better option is to stick to broad spectrum multi-cap funds, where the fund manager decides how much and when to allocate to mid-caps. Either way, any approach to investing in equity funds must take mid-caps into account.