Mutual fund investing: What is the optimum asset allocation across the market cap spectrum?

How many mutual fund investors focus on the market cap of the funds they are investing in? This is a pertinent question considering how many are inclined to study only five to ten years of returns and verify expense ratios before jumping into the fray. Not many pay attention to the market capitalization of the funds or their portfolio details. What they have failed to realize is that different market caps have varying growth prospects. For those who have parked their money into mutual funds hoping to create a corpus, let us study what these market caps mean and how they can help grow your investments.

Large-cap funds

Consistent growth sans less volatility is the hallmark of large-cap companies. However, the growth rate is likely to be moderate. Considering how these funds respond slowly to sudden market corrections, investors must wait for them to stumble and succumb to the extreme and prolonged market falls.

B Padmanabhan, Founder, Fortune Investment Services says, “Large cap fund should invest 80 per cent in large-cap funds and the remaining 20 per cent can be in the mid or small cap which fund managers take a call based on his/her conviction about that category. Most of the large-cap funds are also big-sized because they have no constraint in accepting any money to manage. Because of the size and as it is known to everyone, they are finding it difficult to generate returns in the last 10 years and it’s even more evident in the last five years as well."

“Last, but not least, many good stocks are not available in the large-cap space. Foreign Institutional Investors (FIIs) generally invest in the large-cap so they pull out frequently as compared to small & midcap where investors don’t take out the money invested frequently as they are invested for their long-term goals,” he added. 

Statistics reveal only seven funds out of the 27 large-cap funds that have completed 10 years in the mutual fund industry have outperformed their peers.

Large-cap funds allocate a major chunk of their assets to companies with huge market capitalization. Does this undermine the risk factor? This question is relevant considering how many large-cap companies have sunk in the past causing shareholders to lose their money.

Dev Ashish, Founder, Stable Investor says, “Nifty 50, which is made up of stocks of 50 companies, is accepted to be a well-diversified index. But in the recent past, the high weights of the top few stocks demand the question of whether it is indeed that well-diversified or not.

• Top three stocks in Nifty50 account for about 28 per cent weightage
• Top five stocks in Nifty50 account for about 41 per cent weightage
• Top 10 stocks in Nifty50 account for about 59 per cent weightage

The current weights to the top few stocks aren’t at an all-time high but are still quite close to it. Since the ETFs and index funds in India replicate indices like the Nifty 50, they too expose themselves to this concentration risk which results in a higher concentration of the portfolio in just a few stocks. 

This risk is lower in actively managed large-cap funds as there are SEBI rules and internal guidelines that stop these funds from overexposing themselves to such risks. But still, active large-cap funds are now finding it difficult to beat index returns. I am all in favour of passive products for large-cap exposure. But this is still a risk that passive investors should be aware of.”

When asked why the risk factor still exists in large-cap mutual funds, Ashish adds, “Compared to indices like the S&P 500 and Nasdaq in mature markets, the problem is bigger for Indian bellwethers like Nifty50 and Sensex. Indices like S&P500 and Nasdaq have diversified their portfolio in 500 and 100 stocks respectively. But in India, Nifty has it in 50 and Sensex at even lower 30 stocks. That too skewed towards just a few top five to 10 stocks.”

The size of a fund does not increase its chances of yielding increased returns.

Mid-cap funds

These are mutual funds that invest in the growth story of mid-sized companies in India. Investors prefer parking their earnings in these funds to benefit from their inherent stability. Apart, these funds have performed consistently well over the past few years considering how the companies listed in their portfolios strive to outperform both mid-cap and large-cap companies.

Some of these funds have indeed proved their mettle in the past few years though you must access their fund performance details over a period including in those years when the market had hit rock bottom. Secondly, you must check the portfolio of these funds regularly to assess the allocation they have made in potentially weak companies, thus, spelling chances of low profits or losses in the long run.

Details reveal how 18 of the 27 mid-cap funds launched in the past decade have outperformed the average returns on the midcap index and peer group companies.

Another common mistake that many investors make is withdrawing from these funds once they have increased in size considerably or when some companies from their portfolios transform into large-cap companies. This is because many investors correlate fund size with agility wrongly misconstruing that the rate of returns now would be much lower than before. All funds do not show similar performance. You have to dive deep into research to understand how one fund may be better than the other before deciding which you wish to invest in.

Small-cap funds

This is one category that most optimistic and veteran investors vouch for. However, many are apprehensive about putting their money in them fearing the extreme volatility in the small-cap space. Apart, many investors tend to ignore them owing to the small size of their businesses and negligible operations. In the past decade, many small-cap companies have disappeared into oblivion, thus, destroying shareholders’ confidence and money. This is evident from figures showing how only six funds in India have beaten the S&P BSE Small Cap TRI.

However, many have gained recognition after being discovered by institutional investors who invest in lump sums, thus, pushing the value of their stocks higher.

There is a thing about small-cap funds. These can help you create a corpus while some may cause you to suffer unprecedented losses. Viral Bhatt, Founder, Money Mantra says, “Small-cap funds can perform exceptionally well during a bullish market phase. However, these funds can go through some difficult market phases, leading to an abrupt fall in their returns. Investors should practice caution while investing in these funds. Invest in these funds only if you understand the risk involved in them and you are patient enough to stay invested for longer investment horizons, like a minimum of seven to 10 years.”

The thing is that before investing in small cap funds, it is important to evaluate the financial statements of their portfolio companies and then decide if the fund is investing in stocks of fundamentally reliable and strong companies.

Suresh Sadagopan, Founder, Ladder7 Financial Advisories says, “One should have a long-time horizon, high-risk bearing capacity and be able to stomach volatility in the interim. Only such persons could consider small-cap funds.”

Many new-age investors park their money in small-cap funds to benefit from the volatility. Talking of volatility, even prolonged market lows in 2018 and 2019 and then the sudden market crash in 2020 could not deter small-cap and mid-cap funds from outperforming other mutual fund categories. Some of these investors have gained from market upsides in the past while others perished. Extensive research is needed to earn from these funds considering how their performance can swing in both directions extensively.

Expertise and experience go hand in hand when choosing small-cap funds. Also, you must invest with a long-term investment horizon, thus, ensuring enough time for your investments to grow and compound with time.

Gaining from mutual fund investments

Before investing, it would serve best to compare how the BSE100, BSE Midcap and BSE Smallcap index have fared to date. The higher returns come from the small-cap companies mostly, though you must have the stomach to digest the recurring and extreme volatility at times. There would be times when funds would drop companies from their portfolio list citing them as overvalued only to realize their folly later. Including undervalued companies hoping that they would make it big with time without verifying the companies’ credentials and credibility has cost many small-cap funds big time.

Rahul Agarwal, Proprietor, Advent Financial says, “On a relative basis, funds investing in mid and small-cap stocks tend to be more volatile than funds investing in large-cap stocks. Further, large-cap stocks are very widely followed whereas, in the case of mid and small-cap, there exists the potential to discover relatively unknown stocks that can deliver outsized returns. Due to reasons such as above, the risk premium associated with small & midcap funds is higher and therefore has the potential to deliver higher returns than large caps, as has been witnessed in the past. Simply put, the higher the potential risk, the higher the potential return.”

Determining the right market cap mix

There is no ideal mix for mutual fund investments based on their market capitalization.

Deepali Sen, founder partner, Srujan Financial Services LLP says, “The ideal mix changes from clients to clients. It depends on their future goals, their risk appetite and their understanding of volatility based on their past experiences. On a very broad level, exposure to mid and small-cap stocks should not exceed 25-30 per cent of equity exposure. One could go on the higher side in mid and large provided the goals are 12-15 years ahead or if one is looking at the inter-generational transfer of money."

She added, “While investing across various market caps it is most advisable to stagger the investments over 12-18 months by doing SIPs or STPs. New investors must start investing mostly in large caps, to begin with, and graduating to mid and small caps subsequently with time as they witness volatiles of the stock markets.”

However, analysts suggest that parking 40-50 per cent of the money in large cap, 30-40 per cent in midcaps and the remaining in small-cap and micro-cap funds may fetch you returns that not only beat inflation but also help create a corpus to meet your end financial goals.

Padmanabhan adds, “Last 10-15 years data suggests that mid & small caps are more favourable in the coming decade I personally also feel that mid & small cap will deliver good returns, of course relatively with a little bit of more volatility. Volatility in the long term is your best friend, hope you are aware of the same.”

However, you must be aware that not many research reports are available regarding mid & small-cap funds and, therefore, it requires a lot of skills to identify these stocks. Moreover, the fund size of small & midcaps is generally very small compared to the large-cap category so they are always nimble-footed and take more action than large-cap funds.