Mutual Funds | 05 Oct 2016
The different types of mutual funds in equities
The Different Types of Mutual Funds in Equities
Understanding large cap, mid cap, and small cap mutual funds
When investors look at the different types of mutual funds within equities in India, the one classification they most often come across is based on market capitalization or “cap”. Market Capitalization or cap refers to the rupee value of the total shares outstanding of any company (number of shares outstanding times market price). And based on market cap companies and their stocks can be classified as large cap, mid cap, and small cap.
Defining the different capitalization segments
As the names make clear, large-cap stocks represent the largest companies by market cap that also enjoy a high level of liquidity. These are also called blue-chip stocks.Mid cap stocks refer to those companies which enjoy a good level of liquidity but are medium in terms of size. And finally, small-cap stocks are those stocks that are smaller in size and therefore do not enjoy much liquidity.
Sometimes people mention size cut-offs to divide stocks into the large, mid and small cap. However, market capitalization is determined by market prices of the shares which can fluctuate a lot. Hence it is more useful to follow a simpler rule of thumb such as this one: Consider the top 50 stocks by the market capitalization as large cap, the next 200 as mid-cap, and the next 500 as small-cap stocks.
Both NSE and BSE have indices for tracking the performance of stocks in the different cap segments. The most common equity indices, NIFTY 50 and SENSEX are large-cap indices. Similar indices also exist (from both NSE and BSE) for tracking the performance of other segments.
Equity mutual funds have any ones of these indices as there benchmark and are therefore classified as large cap, mid cap or small cap funds. Multi-cap equity funds are those which can hold stocks from different cap segments. Their benchmark is usually a composite index such as Nifty or BSE 500.
How to choose between large cap, mid and small cap and multi-cap funds?
When you are choosing between different cap funds, the first and foremost thing to bear in mind is that irrespective of the equity segment that you go with, the performance is going to be highly correlated. What that means in simple terms is that if large-cap funds are doing well then you are very likely to find that mid cap and small cap equities are also giving good returns. And if large-cap funds are doing badly/giving negative returns then mid cap and small cap funds will also be performing badly except on rare occasions. Performance of multi-cap funds is just like an average of these different categories, depending on how much of each category does the multi-cap fund hold.
In the chart below, I have shown the historical monthly performance of Nifty 50, Nifty Mid Cap 100 and Nifty Small Cap 100. The chart shows money in each index would have grown if you had started with Rs. 100 in Jan 2004 (ignoring any dividends). As you can see, all the three indices move pretty much in lockstep with each other. For those who are mathematically inclined, the average correlation between these indices is greater than 90%.
So is cap irrelevant then? No. While large cap, mid cap, and small cap equities move together, mid cap and small cap equities tend to run ahead of large-cap equities. This is true on both the upside and downside. If we go back to our figure, the period between 2004 and 2007 was an extremely good one for Indian equities and the Indian economy in general. Over this period large-cap equities went up by 34% p.a., mid-cap by 39% p.a. and small cap by even more at 55% p.a. On the other hand, equities did pretty badly in 2008 due to the global credit crisis. Over this period, the large-cap index was down by 52%, mid-cap index by 59% and the small-cap index was down by the most at 71%. Another way of saying the same thing is that smaller cap equities have a beta of >1 to larger cap equities i.e. when larger cap equities move by x%, smaller cap equities move by >1*x%. In the Indian case, the beta of mid-cap equities and small-cap equities to large-cap equities has been 1.06 and 1.16 respectively.
There are three clear investment implications from our discussion above:
First, mid and small cap funds are riskier than large-cap funds. They will lose a lot more during bear markets. However, this risk also comes with the promise of higher returns. The return and risk for multi-cap funds fall somewhere between the two.
Second, investors should not think of investing in different cap funds as diversification. Yes, there is some diversification to the extent that funds managers of different funds follow slightly different strategies, but do not expect your mid and small-cap fund to give positive returns when large-cap funds are in the red and vice versa.
Third, for investors interested in market timing, if you have a strong view that equity markets are going to do well in a certain period, then investing in mid and small cap funds instead of large-cap funds makes sense. These funds will go up by the most in case your view comes true. In fact, holders of multi-cap funds may notice their fund managers following this kind of a strategy – increasing allocation to mid cap and small cap equities when they expect equity markets to do well and preferring to stay in large-cap equities when they expect uncertain times.
To see how ELSS funds fit in this spectrum, Read: How do ELSS funds compare with other equity funds
Created by Orowealth.com