In the past few months, we have seen investors, especially new investors, simply picking funds in the mid- and small-cap category based on high returns . While we think mid-cap funds should find a place in every long-term portfolio, excessive exposure to this space, especially after a sharp run-up, can be harmful.
In this piece we’ll cover why you need to tread with caution when you go overweight on this market cap segment based on past returns. For this purpose, we will specifically look at the small-cap category, as far as funds go, as this is the segment that has seen the largest increase in investor interest.
We often ask you to look at long-term returns while picking funds. But then, is that sufficient? If you invested in mid- and small-cap funds based on their stellar 3-year returns, here are some facts you should know: These returns appear superlative as they are point-to-point returns with a base of 3 years ago, when the market was at a low in the pre-election year. This was also a time when mid- and small-cap stocks were really cheap, having very poor fundamentals and bleak earnings growth. Hence, your 3-year returns have a low base that can be deceptive.
Next, look at the price earnings ratio, a key valuation metric used in the stock market to determine a stock’s valuation in relation to its earnings. As can be seen in the table below, from a point three years ago, when large-cap stocks were higher in valuation by a small margin, mid-caps are now at a significant premium compared with large-caps. Such a wide margin often indicates bubble territory.
Now, if you do some simple math on the earnings of the mid-cap category (based on the mid-cap index level and the trailing P/E ratio), you will be surprised to know that earnings fell an absolute 5.5 per cent in the last three years, while the index close to doubled!
|Price earnings ratio|
|Now||3 months ago||6 months ago||1 year ago||3 years ago|
|As of July 19, 2016|
Hence, now at a valuation of over 33 times, the earnings growth of companies in the small- and mid-market-cap segment will not find it easy to catch up with the index price run up. Essentially, this is a case of stocks rallying way ahead of the earnings. Over the same period, you will see that large-cap valuations have moved in a more measured way. Recent 3-month and 6-month data shows that large-caps are catching up in terms of returns, without any undue movement in their valuations. And this is with a significant expansion in earnings in the March quarter.
What does this mean for your mutual fund investments? Simply this: Don’t be disenchanted by the poor 1-year returns of the large-cap category, and do not be misled by the higher returns of mid- and small-cap funds over the same period. What needs to be looked at is whether this market cap segment can continue to deliver the same returns at this stage as it did in the past.
|3 months||6 months||1 year||3 years|
|Nifty Midcap 100||7.00%||16.00%||4.00%||23.80%|
|Returns as of July 19, 2016. Returns for funds are category averages. 3-year returns are annualised.|
High standard deviation
Mid- and small-cap funds, as a category, also have high swings in their returns. In other words, their standard deviation is high. We have seen a case of high returns from mid- and small-cap funds. But a high standard deviation means that they can also fall significantly. The numbers below will tell you that the volatility of small-cap funds is twice as much as that of large-cap funds. Hence, while you may be happy seeing high returns in these funds, whether you will be able to take the falls is what will determine whether these funds are really for you.
|Standard deviation based on daily rolling 1-year returns over the past 3 years.|
Too swift for comfort
While you may be enamoured by the kind of returns that small-cap funds delivered in the past one year, it is important for you to know about the underlying stocks in these funds. A very direct challenge for fund managers would be to find such winning stocks time and again in this category, given that not many stocks will be fundamentally sound for a fund to pick.
In fact, this is one reason why some fund houses with small-cap funds have actually curtailed investments in their fund by either stopping lump sum investments or limiting them. This itself should give you an indication of the challenges they face in deployment.
There is another real challenge for these funds that arises from illiquidity, especially in small-cap stocks. Due to their illiquidity, these stocks cannot be liquidated by the fund manager in one shot at the appropriate time. Let us take the case of Atul – a stock with a free-float (shares available for being freely traded) market cap of about Rs. 3,100 crore and held by small-cap funds such as DSP BR Micro Cap or Reliance Small Cap (taken for illustrative purposes only).
On an average (in the past 2 weeks), the share’s daily traded volume in the exchange was about 3,370 (quantity). Now, the DSP fund has over 4 lakh shares while the Reliance fund has over 3 lakh shares (not to mention that other funds from the same stable that also take exposure to this stock). Can you imagine how many days it will take for these funds to sell them entirely, when they have to?
Two scenarios can play out: One, if the fund is selling because it has made enough profits, the real profits it will book may be much lower as it will be selling over several weeks to reduce or sell off its position. Two, and more importantly, if the stock turns out to be a wrong pick, or if it is being pulled down due to certain news, the fund will be stuck with the stock as its normal trading volume comes further down, with fewer takers for the shares. This illiquidity risk is what finally shows up in your funds as high volatility or sudden dips in returns.
How to deal with it
This is not to frighten you into not benefitting from the high return potential in this category. All that you need to do is keep your exposure limited, and enter these funds through SIPs.
What if you already hold a chunk of your investment in this category? If you have been holding for long and have very high double-digit returns, you can consider switching some money to a large-cap fund. But if you entered it recently (which is likely as the mid- and small-cap category has seen more inflows from investors in recent times), do not try and exit now as you will incur costs and taxes.
The best you can do to rebalance is to make your future investments, or add more investments now, in large-cap and diversified funds, as this is also a good time to enter the large-cap category given the relatively reasonable valuations. This will also help bring down overall your exposure to mid- and small-caps, and thus reduce the volatility in your portfolio.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.