How much mid and small cap allocations you should have in your portfolio

One question which we often see in Quora and other social media platforms is, “In what proportion should I invest in large cap, midcap and small cap funds”. Your financial advisor may have recommended a mix of large cap, multicap, midcap and small cap funds, but you should try to understand the basis of allocation to different market cap segments. Often market cap allocations are based on thumb rules or subjective notions of risk. In this blog post, we will discuss a logical framework, which you can allocate your equity investments to different market cap segments. You will also have to use your own judgement based on your risk appetite or consult with your financial advisor. First let us understand what these market cap segments are.

Market capitalization segments

SEBI has come up with a clear definition of the 3 market cap segments:-

• Large Cap: Top 100 stocks by market capitalization


• Midcap: 101^st to 250^th stocks by market capitalization


• Small Cap: 250^th and smaller stocks by market capitalization

Risk/ Return characteristics of different market cap segments

The chart below shows the risk return characteristics of different market cap segments -

You should always understand the risk profile of a mutual fund scheme and make informed investment decisions according to your investment needs and risk appetite.

Suggested reading – How to choose the right mutual funds according to your need

How to allocate your portfolio among large and mid/ small caps?

You will often see that investment experts/ advisors suffix their views by saying, “you should invest according to your risk appetite”. While risk of a mutual fund scheme can be quantified using measures like standard deviation, beta etc, the notion of risk appetite is usually quite subjective. Your financial advisor may use a risk questionnaire to ascertain whether you have low, moderately low, moderate, moderately high, high or very high risk appetite. While there may be some subjectivity involved in assessing your risk, you have a starting point for making investment decisions.

You need to have moderately high to higher risk appetite for investing in equity funds. If you do not have moderately high risk appetite then you should invest in fixed income funds or funds that have a sufficiently large percentage of its assets in fixed income or debt. Now let us assume that you have moderately high or high risk appetite. Should your market cap allocation be 50 (large):30 (mid):20 (small) or 70:20:10 or something else? There is a fair amount of subjectivity in such thumb rule allocations. In order to have logical framework for market cap segments allocations, trying to understand the allocation of the overall stock market may be useful.

What is the market cap allocation of the overall stock market?

The chart below shows the percentage of the 6 month average market capitalization ending 31^st December 2020 of all stocks on the National Stock Exchange comprised of Top 100 stocks i.e. large cap, 101^st to 250^th stocks i.e. midcap and 250^th and smaller stocks i.e. small caps.

Source: AMFI, as on 31^st December 2020

Below is the same chart (6 month market capitalization ending 31^st December 2020 of different segments) for Bombay Stock Exchange. You can see that percentage break-ups of large cap, midcap and small cap are similar for both the exchanges. BSE has more small-cap stocks listed on it compared to NSE, so percentage of small caps is slightly higher.

Source: AMFI, as on 31^st December 2020

You may ask why this information is relevant. The stock market represents all the investors (retail, HNIs, NRIs, mutual funds, FIIs etc). The market cap composition of the market represents the average risk appetite of all the investors. Building on this premise, if you think that your risk appetite is same or around the same as average of all investors in the market, your large cap allocation can be in the range of 70 – 80%. The balance can be allocated to mid / small caps depending on your risk appetite. Small caps have higher risk profiles than midcaps. You should understand the risk profile of your investment and make informed decisions.

Performance of large and midcap portfolio

The chart below shows the growth of Rs 10,000 invested in large cap (Nifty 100 TRI) and a portfolio comprising of 75% large cap (Nifty 100 TRI) and 25% midcap (Nifty 150 TRI) over the last 20 years ending 31^st March 2021. You can see the portfolio of large and midcap was able to outperform large cap without too much incremental volatility.

Source: National Stock Exchange, Advisorkhoj Research. Period: 1^st April 2011 to 31^st March 2021. Disclaimer: Past performance may or may not be sustained in the future.

Can you have higher / lower allocations to mid/small caps?

If you have higher risk appetites, you can have higher allocations to midcap and small cap. Risk appetite can depend on a variety of factors; an important factor is age. Lower your age, higher is your risk appetite and vice versa. The age wise distribution of India’s population as follows (please note that we have not considered the “below 25” age group because most of the people in this age group are unlikely to be investors in equity):-

• 25 to 44 years: 27.6%


• 45 to 64 years: 13.5%


• 65 and above: 4.80%

Source: Government of India Census

About 60% of population, who are above 25, fall in the 25 to 44 age group and 40% of the population are in 45 and above age group. This shows that despite 60% of the population being lower than 45 years of age, there is a significant bias towards large cap (74% of total market cap). If you are towards the lower end of the 25 to 44 age bracket, you can have higher allocations to midcap and small cap (25 to 30% or higher). If you are closer to 45 years or older, you may be approaching important life-stage goals e.g. children’s higher education, children’s marriage, retirement etc.; you will then have higher allocations to large cap i.e. 75 – 80% or higher.

Conclusion

You should note here that we have laid out a market data based framework of how you can approach diversifying your portfolio across different market cap segments. Your allocation will depend on your own risk appetite, your financial goals and personal situation. Here are the things you should consider:-

• Your investment experience: If you are a new investor, your portfolio can start by investing in primarily in large cap funds. As you gain experience and get used to market volatility you can add midcaps and small cap funds to your portfolio.


• How you plan to invest: Since midcaps and small cap funds are more volatile than large cap funds, systematic investment plans can be used to take advantage of asset volatility through Rupee Cost Averaging.


• Take a portfolio view: Investors should note that we have discussed market cap segments and not fund categories. Different fund categories have different market cap mandates. Large cap funds invest at least 80% of their assets in large cap stocks. Large and Midcap funds invest at least 35% each in large and midcap stocks. Multicap funds invest at least 25% each in large, mid and small cap stocks. Midcap funds invest at least 65% in midcap stocks. Small cap funds invest at least 65% in small cap stocks. Flexi cap funds can invest across any market cap segments. You should always take a portfolio view when managing your asset allocation. You should know how much large cap, midcap and small cap you have in your overall portfolio and manage accordingly. You should consult with your financial advisor, if required.