Retail investors who are new to equity markets usually prefer large cap stocks or mutual funds. Investors often view large cap companies as safer investment options compared to small and mid cap companies. Large cap funds are less volatile than midcap funds and their downside risks are limited in bear markets. Due to outperformance of midcap funds in the last couple of years, many retail investors in India are now showing a preference for midcap funds. While midcap funds have the potential to give higher returns in the long term, investors should remember that they are more volatile than large cap funds. Also, selecting small and midcap funds that may give high future returns is not an easy task. The performance of midcap funds tends to be volatile across years. Large cap and midcap funds tend to outperform each other in different market conditions. As discussed earlier in our blogs, recent performance may not be a good indicator of future performance. As a long term investor, you should delink your investment decisions from current market conditions, because market conditions can change very quickly. As such diversified multicap funds, which invest across different market capitalization segments and industry sectors, are ideal for retail investors. These funds are variously known as, diversified equity funds, multi cap funds, flexi cap funds etc. While there may be nuances in investment styles of some of these funds, essentially these are equity funds which invest in large cap, midcap and small cap companies and are in a variety of industry sectors to provide risk diversification for investors and also good returns in the long term.

Market cap exposure of different fund categories

We should clarify here that, even the large cap funds may have exposure to small and midcap companies. On the other hand, small and midcap funds may have a portion of their portfolio invested in large cap companies. What distinguishes a large cap, small & midcap and diversified fund is the market capitalization weights in their portfolio. Large cap funds usually have more than 75% of the portfolio invested in large cap companies. Examples of large cap funds are HDFC Top 200 fund, ICICI Prudential Focused Bluechip Fund, Reliance Top 200 fund, Birla Sun Life Top 100 fund, Franklin India Bluechip fund etc.

Small and Midcap funds usually have more than 55% of their portfolio invested in small and midcap companies. Examples of small and midcap funds are HDFC Midcap Opportunities fund, Reliance Small Cap fund, Franklin India Prima fund, SBI Magnum Midcap fund, IDFC Premier Equity fund, DSP Black Rock Microcap fund etc. Diversified equity funds, which invest across market caps and sectors, can have 45 – 75% of their portfolio invested in large cap companies and the balance in small and mid cap companies.

Benefits of diversified equity funds

Diversified equity funds, which invest across market capitalizations, have several advantages compared to funds focused on any particular market capitalization.

1. Different segments of the market outperform each other in different market cycles. For example large cap companies outperform midcap companies in bear market conditions and in the initial phase of the bull market. When large cap valuations run up in bull markets to a point where they appear stretched, midcap companies tend to do better. Return of midcap stocks which had been trailing the large cap stocks for the greater part of 2013, in terms of returns, caught up with the large cap stocks by the end of the year, and in 2014, especially after the general elections, small and midcap stocks have outperformed the large cap stocks. The outperformance of the midcap segment has continued even in the volatile market conditions this year. Diversified equity funds have both large cap and midcap companies in their portfolio, and therefore have the potential to deliver good performance on a more consistent basis.


2. Diversified equity funds have the potential and tend to outperform large cap funds in the long term. The diversified funds have 25 – 50% of their portfolio invested in small and midcap companies. Small and midcap companies have the potential to give higher returns than the large cap companies, because of their earnings growth potential and relatively lower valuations. During bull market rallies, the valuations (P/E multiples) of large cap stocks, which are richer than midcap stock anyway, run up faster and unless earnings growth keeps pace, the valuations can look stretched, making the investors wary. Small and midcap stocks tend to outperform large cap stocks in bull markets. As a result, diversified equity funds tend to outperform purely large cap funds in bull market conditions. Indian retail investors should also note that impact of Foreign Institutional Investors (FIIs). FIIs invest primarily in large cap companies. Therefore their activity has a huge impact on share prices of large cap companies. FII activities are mostly driven by global factors and therefore, even if the domestic factors are favourable, share prices of large cap companies can suffer because of global risk sentiments. We saw this year, share prices of large cap companies taking a beating because of global issues primarily. On the other hand, small and midcap companies are relatively more insulated from FII activities.


3. While in bull markets small and midcap stocks rally, in bear markets they suffer sharp declines. In fact, if we refer back to the great recession of 2008, many small and midcap companies suffered permanent damage to their fortunes. Also, as Prashant Jain of HDFC mutual fund puts it, only a few small and midcap companies eventually become large cap companies. As a result, while valuations of some midcap companies keeps improving with earnings growth, valuation of many midcap companies do not increase beyond a point. The other issue faced by investors in midcap companies is liquidity or the lack of free float stock. Free float stock is the number of shares held by the public investors, including us retail investors, as opposed to locked in stock held by the promoters, company management and other controlling interests. Therefore, if an investor or fund manager wants to sell large volumes of midcap stocks, they may not always find buyers in the market. Consequently, small and midcap funds face liquidity constraints when redemption pressure increases in bear markets. Diversified equity funds on the other hand do not face liquidity problems, since large cap stocks comprise a substantial portion of their portfolio.


4. Retail investors tend to be influenced by “recent” outperformance. In bull markets investors tend to shift from large cap to midcap funds, which give higher short term returns. Similarly in bear markets, investors tend to redeem or stop SIPs in their midcap funds due to the volatile NAVs. However, short term performance may not be a good indicator of future performance. Long term performance depends on fundamentals like economic outlook, company and sector growth potential, fiscal policies etc. Fund managers of diversified funds invest in large, mid and small cap stocks based on the long term growth potential. They also change their portfolio allocations between market capitalizations and sectors, to maximize fund performance within defined investment objectives. Investing in diversified funds precludes the tendency of investors to switch between large and midcap funds based on short term performance.

Diversified funds have outperformed large cap funds on a fairly consistent basis

Over the last ten years diversified funds which invested across market capitalizations and sectors outperformed large cap funds on a fairly consistent basis. The chart below shows the annual returns of large cap and diversified multi-cap funds over the last ten years, from 2003 to 2013.

We can see in the above chart that diversified funds have outperformed large cap in most years in the 10 year period from 2005 to 2015. Even in the market downturns the performance of diversified funds and purely large cap funds were more or less similar. Thus we have seen that, while diversified funds have outperformed large cap funds in bull markets, their downside risk is limited almost to the same extent as the large cap funds. These funds are therefore ideal for the retail investors.

Top performing diversified funds outperformed top large cap funds by a bigger margin

While diversified funds which invested across market capitalizations and sectors outperformed large cap funds as a category, the difference in returns of top performing funds in both categories on the basis of last 3 years annualized returns is even bigger. We have selected top 5 funds in both diversified and large cap funds categories, on the basis of their 3 years trailing annualized returns. Please note we have considered only regular plans and selected funds from only the top AMCs with sufficiently large AUM base (at least Rs 200 crores). The chart below shows the trailing annualized 1 year, 2 years and 3 years returns of top 5 diversified funds. Returns based on NAVs as on Dec 31, 2015.

Now compared to the top diversified funds, please see the chart below for the trailing annualized 1 year, 2 years and 3 years returns of top 5 large funds. Returns based on NAVs as on Dec 31, 2015.

On a 3 year trailing basis top performing diversified funds have 2 -10% higher returns than their large cap counterparts. The diversified funds which invested across market caps have generated superior risk adjusted returns in terms of alphas compared to the large cap funds.

Choose Diversified Funds wisely

There are a large number of diversified funds in the market. However, not all the funds have given good returns. There is a large performance differential between funds in top quartile and bottom quartile, for any given performance period. Funds in the top quartile gave much better returns compared to funds in the bottom quartile. Short term performance is not a good indicator of long term performance potential of a fund. Investors should consult with a financial advisor to select a fund that has given strong consistent performance.

Conclusion

In this article, we have discussed that the diversified equity funds which invests across market capitalizations and sectors are ideal for retail investors. As such these funds should form a substantial part of an investor’s mutual fund portfolio. How much should an investor allocate to large cap funds, small cap funds and diversified funds? You can allocate 100% of your portfolio to these funds. After all, a diversified fund acts like a portfolio of large cap and midcap funds. Some financial advisors recommend allocating 30% of the portfolio to large cap funds, 20% to midcap funds and 50% to diversified multicap funds. There are no hard and fast rules. Based on your risk tolerance and investment objectives you can work with your financial advisor to develop your mutual fund investment plan and select suitable funds for your portfolio.

(First published in Advisorkhoj.com)

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.