Small and Midcap Mutual Funds are now outperforming Large Cap Funds

While the performance of equity funds last year had been in general, lackadaisical, the performance of the small and midcap funds category has been particularly tepid. The average return of small and midcap funds category in 2013 was only 2.31%, compared to 6.75% average return given by the large cap funds category. However, 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 over the past few months, especially after the elections, have outperformed the large cap stocks. The chart below shows the daily trend of Sensex, BSE – 100 and the BSE – Midcap index for the last year. For the purpose of comparison, we have indexed the values of all the three indices on June 20 2013 to 100.

Small & midcap funds have also been trailing large cap funds for most part of 2013. However, since September 2013, the performance of the small and midcap funds category has been quite spectacular, and this category has been clearly outperforming large cap funds. The chart below shows the trailing returns over the last 1 month, 3 months, 6 months, 1 year and 3 years (annualized) returns, of small & midcap funds and large cap funds categories.

Small and midcap funds are inherently more risky than large cap funds, but they have the potential to generate higher returns compared to large cap funds. Small and midcap funds especially do well in times, when valuation of blue-chip and large cap stocks seem a little stretched. Large cap funds and midcap funds outperform each other in different time periods. This is due to a number of reasons:-

• At the beginning of a bull market rally, such as the one we have seen over the past year or so, the funds of Foreign Institutional Investors (FII) generally flow into the large cap stocks. This causes the large cap stocks to run up significantly in value to level at which, the valuations of the large cap stocks, seems a wee bit stretched. This is when midcap stocks seem more attractively valued relative to the market, and therefore outperform large cap stocks.


• From a valuation perspective, midcap companies have greater earnings growth potential because of their smaller sizes. If earnings (or EPS) grow faster, the stock prices also tend to appreciate faster.


• Midcap companies tend to be under-researched compared to the large cap companies. This gives rise to, what is known as, “valuation arbitrage”, which means companies which are under-researched have lower valuation. As midcap companies grow over time, their valuations also improve.

Since large cap funds and midcap funds outperform each other in different time periods, it is a good idea to have midcap funds, along with large cap and diversified equity funds, in your portfolio. Since the universe of small & midcap stocks is much larger than large cap stocks, stock selection and portfolio construction in small & midcap funds result in big differences in fund performance. The difference in performance between the top quartile and bottom quartile is bigger in the small & midcap funds, as compared to large cap funds. The chart below shows the returns between the top performer and bottom performer in small & midcap funds category.

Therefore, it is very important that you select top performing small & midcap funds for your portfolio. As you can see, the top performing funds did significantly better than the bottom performers in the small & midcap funds category over these various time periods. Your financial adviser can help you select the right funds for your portfolio

Conclusion

Midcap funds have the potential of giving superior returns compared to large cap and diversified equity funds. There is a lot of misconception in our country regarding small and midcap companies. However, in reality, many midcap companies have over time, become large cap companies. Investors in these companies have got excellent returns. Midcap funds are excellent instruments, through which you can invest in high quality small and midcap companies. However, you need to have a long time horizon for your investment in small & midcap funds. As discussed earlier, large cap funds and midcap funds outperform each other in different time periods. Therefore, small & midcap funds should form a part of your mutual funds portfolio, so that you can benefit over different stages of your investment horizon. In our next article, we will discuss some top small and midcap fund picks for your portfolio.