Mid-cap and small-cap mutual funds are trailing their benchmarks; should you be worried? For many mid-cap funds, it is the large-cap exposure that has put a lid on returns. Most mid-cap funds typically retain 10-20% exposure to large caps to maintain portfolio liquidity and hygiene
Mid-cap and small-cap funds have put on quite a show over the past year. Yet, most of these have sharply lagged behind their respective indices during this time frame. While small-cap funds have averaged 34% over the past year, the Nifty Smallcap250 TRI has gained 38%. Only seven out of the 24 small-cap funds have beaten the index. Similarly, mid-cap funds have averaged 28%, even as the Nifty Midcap150 TRI has gained 33%. Only three of the 28 mid-cap funds have beaten the index.There are multiple reasons why mid-cap and small-cap funds are trailing their benchmarks. For many mid-cap funds, it is the large-cap exposure that has put a lid on returns. Most mid-cap funds typically retain 10-20% exposure to large caps to maintain portfolio liquidity and hygiene. Juzer Gabajiwala, Director, Ventura Securities, observes, “Many mid-cap funds have a heavy presence in large-cap stocks, apart from the mandatory mid-cap allocation.” However, the large-cap basket has fetched paltry returns relative to the uptick in the broader market. Consequently, mid-cap funds with a meaty allocation to large caps have seen a drag in performance. Axis Midcap, LIC MF Midcap and Canara Robeco Midcap run allocations in excess of 20% to large caps.
Besides, the broader market has not participated evenly in the big upswing. Pankaj Shrestha, Head, Investment Services, Prabhudas Lilladher Wealth, remarks, “The stocks that have seen the biggest surge find modest representation in mid-cap and small-cap funds.” Several high-flying, mid-sized PSU stocks find little or zero allocation in most mid-cap fund portfolios. For instance, not a single actively managed mid-cap fund has bet on The Fertilisers and Chemicals Travancore, a stock that surged 378% over the past year. Only five small-cap funds have bet on Suzlon Energy, which soared 414% during this period. Many other chart toppers simply do not meet the quality and hygiene filters employed by fund managers. Roopali Prabhu, CIO and Head of Products and Solutions, Sanctum Wealth, observes, “Several mid- and small-cap funds are constrained as their investing discipline doesn’t encourage participation in illiquid stocks or specific segments like PSU names.”
The heavy inflow in small-cap funds has put fund managers in a fix. Finding new ideas in this space is tricky. The funds cannot absorb the inflow without diluting the mandate. A few fund managers have run higher cash positions or ventured into lower quality names, diluting fund performance.
Lagging behind the indices
Mid-cap funds have lagged in one-, three- and five-year time frames.
“In small-cap funds, there is a limit on how much money can be deployed at any time. When money comes at a faster pace than can be deployed, funds either experience a style drift, run higher cash positions, or build longer tail portfolios,” points out Prabhu. Gabajiwala remarks that several small-cap funds have ventured into names beyond the 500th stock by market capitalisation, the predefined cut-off for these funds.
The dispersion in returns in this space has also narrowed, observes Kirtan Shah, Founder, Credence Wealth Advisors. “What worked for small-cap funds initially was that the stocks were broadly performing and, most funds did well. Now it has narrowed and they are finding it difficult to beat the index.” However, experts insist this underperformance does not reflect poorly on the investment choices of mid-cap and small-cap funds. “This underperformance is more circumstantial than structural,” insists Prabhu. “There is still a lot of information asymmetry in the mid- and small-cap space that can be exploited by quality active fund managers to outperform the index.” Further, many mid-cap and small-cap funds tend to outperform sharply when the markets are weak. This makes up for any underperformance during a broader market uptick. Data from Morningstar indicates that over the past five years, mid-cap funds have captured 94% of the index uptick, even as they have protected the downside better by capturing only 87% of the index drawdowns. These figures hold over a 10-year horizon as well. Similarly, over the past five years, small-cap funds have captured just 91% of the index upside, while limiting the downside to 83%. Over 10 years, the upside and downside capture ratio of small caps stands at 89% and 77%, respectively. Clearly, it is the superior performance during market declines that sets up most mid-cap and smallcap funds for outperformance over longer time frames. Shrestha explains, “Many of the factors that work against these funds during the broader market uptick—presence of large caps, cash positions—goes in their favour when the tide turns.”
Exposure to large caps lowers returns
Most mid-cap funds do this for portfolio liquidity and hygiene.
Even so, investors should be wary of funds that are lagging acutely. These funds may struggle to close the gap even when the cycle turns. Experts reckon fund selection in mid-and small-cap categories has become critical now. With funds mostly investing the bare minimum 65% required to adhere to the chosen mandate, investors must monitor how fund managers are using the leeway to invest the remaining 35%. “With dispersion in fund returns more pronounced in these segments, fund selection is key,” insists Prabhu. Gabajiwala asserts investors also manage their return expectations better. “If your fund is fetching the return expected initially, it should not bother you if its index or other funds are temporarily doing better,” he says.
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This story originally appeared on: India Times - Author:Faqs of Insurances
