Individuals are increasingly investing in mid-cap funds for higher returns and over a period these have become an important part of the portfolio. Since January this year, the net inflow in mid-cap funds is Rs 16,025 crore as compared with Rs 14,565 crore in large-cap funds, data from Association of Mutual Funds in India show.
Mid-cap and small-cap funds have shown strong performance over the past three years with annualised returns in the range of 22% to 30%, outperforming large cap funds by a good margin. Harshad Chetanwala, co-founder, MyWealthGrowth.com, says since most of the equity diversified funds are large-cap oriented, having an allocation in mid-cap funds can be useful. “Over the period many companies in the mid-cap segment do have the ability to grow at a better rate than some of the large-cap companies, hence the allocation in mid-cap funds can be helpful,” he says.
While investors are enthused by these returns and are investing in these categories, experts say it appears to be a bit of performance chasing behaviour, which investors need to be careful about. Valuations play an important role in driving returns as well as drawdown risk in investments.
Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says investing at high valuations, typically observed after periods of strong performance, results in lower future returns and higher drawdown or downside risk. “When investing in mid-cap funds, besides valuations, one should consider the long-term track record of the fund across various market cycles. As the performance of mid-caps tend to more volatile, it is advisable to invest in at least two to three mid-cap funds rather than concentrate on a single fund,” he says.
While mid-cap stocks are highly volatile, they are less risky than small-cap stocks. Within the mid-cap funds, some funds do invest a part of their portfolio in large-cap companies and these funds may face less volatility in a falling market. However, the mid-cap funds will have most of the portfolio invested across mid-cap and small-cap companies and that is why these funds can be more volatile.
The current market scenario is highly volatile due to global uncertainties relating to geo-politics, inflation, spiralling inflation, increasing interest rates globally, liquidity withdrawal by central banks and an overall sense of chaos. Amidst all this, Indian equities have outperformed their global peers on a year-to-date basis. Bond yields are also rising and offer good value on a risk-reward basis.
Harish Menon, co-founder and head, Investments and Product Research, House of Alpha, says the key risk in such a scenario is that of flight to safety by selling equities and buying bonds. “When there is an equity market sell-off, mid-cap funds generally witness heavier redemptions due to their inherent higher risks than that of large-cap stocks. Many mid-cap stocks do not have adequate free-float liquidity in secondary markets and as a result the price impact is more severe,” he says.
Level of allocation
Though the nature of mid-cap stocks is inherently more risky than their larger peers, the expense and turnover ratios of mid-cap funds may not always be higher than actively managed large-cap funds. Expense ratio is a function of scheme assets under management (AUM) and some mid-cap funds have larger AUM than large-cap funds and have lower expense ratios. “The turnover ratio of the scheme depends on the fund management style of the investment team. Even within mid-cap funds, many schemes have lesser churn than their peers,” says Menon.
Experts suggest investors should avoid mid-cap funds if the investment horizon is short as these can be very volatile in the short term and the allocation should be less than 20% of the total investment portfolio. “Depending on the risk appetite one can consider an allocation of 20% in mid-cap funds. One has to keep in mind that the investment horizon in mid-cap funds should be long-term as these funds can deliver much better returns if they are held for a longer period,” says Chetanwala.
HEDGE THE BETS
Invest in at least two to three mid-cap funds rather than depending on a single fund
While mid-cap stocks are highly volatile, they are less risky than small-cap stocks
When there is an equity market sell-off, mid-cap funds witness heavier redemptions
Besides valuations, check the fund’s track record over various market cycles