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A checklist before investing in mid and small cap funds
05 Jan 2023

Over the last 3 years, mid cap and small cap stocks have outperformed the large cap stocks by a margin. Interestingly, even in down markets, the mid caps have not grossly underperformed the large cap stocks as used to be the case in the past. There have been some genuine reasons for this trend. Firstly, mid-caps have been big beneficiaries of the dividends of cheap oil. This has done a world of good for their cost structures and their operating margins. Secondly, unlike a lot of large cap companies operating in sectors like power, telecom, infrastructure and metals; the mid cap companies are not over-leveraged. Hence the level of financial risk is much lower in these stocks. Thirdly, these mid caps have consciously chosen to stick to their core competency rather than trying to diversify into unrelated areas. This has helped them better manage the business cycles.

Obviously, the superior performance of the mid cap and small cap stocks has percolated into the dedicated mid-cap and small cap funds too. However, it needs to be understood that investing in mid-cap funds is a slightly different ball game compared to large cap funds as they do not offer the benefit of diversification. Here is a checklist of 7 important points that you need to understand and remember before investing in these mid-cap and small cap funds..


Checklist before investing in mid-cap and small cap funds..

Performance is the acid test of any mid-cap or small cap fund. We are talking of a consistent performance over the last 4-5 years. While this may not be an assurance of future returns, this is the closest you can get to assurance of good performance. There is a reason for that. Unlike large cap stocks, mid caps are extremely heterogeneous. Therefore, they are less vulnerable to economic cycles and hence a bottom-up stock selection approach works better in this case. Consistent performance for a sustained period of last 5 years is a good indication of good stock selection skills displayed by the fund manager.

Invest in mid-cap funds for the alpha and not for the Beta. Large cap funds can, perhaps, give you beta-plus returns! But for that excess returns, you need mid cap funds. Therefore, what is important is your proportionate exposure to these mid-cap funds. Ideally, you need to ensure that once the good funds are selected, you restrict your overall exposure to these mid-cap and small cap funds to around 20-25% of your overall equity mutual funds portfolio.

Liquidity ratio is the Holy Grail for mid-cap funds. CRISIL calculates the Liquidity score for most mid-cap and small cap funds. What exactly is the Liquidity Ratio? It represents the number of days it will take for the fund manager to wind down the entire portfolio without negatively impacting prices. Interestingly, most diversified large-cap funds have a liquidity ratio of 1.1 to 1.3 days while mid-cap funds have a liquidity ratio of 9-11 days. As you go down to small cap funds, the liquidity ratio can go as high as 25 days. This can matter a lot in volatile times or when there is a rush for redemptions.

Vote for the stability of the fund management team. Investing in mid-cap and small-cap funds is an art that is perfected over a period of time. Hence the consistency of the fund management team is critical in this case. Avoid mid-cap funds where the core fund management team has been going through consistent churn. That does not bode too well for the future of the mid cap fund.

Compare on risk adjusted returns. When it comes to mid-cap funds and small-cap funds, it is quite easy to enhance your returns by adding high risk stocks to your portfolio. Hence risk-adjusted measures like the Sharpe Ratio and the Treynor ratio become important. You do not want a fund manager who is giving more returns purely by assuming more risk. That is not what you pay the fund manager for.

Focus on the mid-cap fund performance in the downturns rather than in the upturns. This is important for 3 reasons. Firstly, mid-cap funds normally tend to outperform in a good market and hence the actual stock selection can get hidden under a larger wave. A down market presents a clearer picture. Secondly, in a down market the ability of the fund manager to manage risk becomes more critical and that is the true test of a mid cap fund. Lastly, stock picking becomes paramount in a down market as the fund manager actually needs to separate the wheat from the chaff.

Lastly, there is one thing that all investors in mid-cap funds and small funds have to be cautious about. Remember, there is a limit to the quantum of quality mid-cap and small-cap stocks available in the market. We have seen in recent past, a very reputed mid and small cap fund restricting fresh sales on the fund as it found limited opportunities to invest in mid-cap stocks at attractive valuations. So, if you are looking at future mid-cap investing opportunities, this may become a constraint.

The bottom-line is that mid-cap funds are a must in every portfolio for that much-needed alpha boost to your portfolio. A better understanding of the pre-conditions of buying mid-cap and small cap funds can help you make a better decision.

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