Insight into to a new mutual fund category: Large and Midcap Fund

If you like to research different mutual funds before investing or are generally interested in mutual fund research, you may have come across a new equity fund category, Large and Midcap Equity Funds. This new category came into being after all asset management companies (AMCs) recategorized their mutual fund schemes to comply with SEBI’s mutual fund reclassification directive. Based on queries and comments received by Advisorkhoj, we have seen that many investors are confused about this category. In this blog post, we will discuss the Large and Midcap Equity Funds category, so that investors are able to make informed decisions when selecting mutual fund schemes for investments.

What are Large and Midcap Fund equity funds?

These are equity funds which invest at least 35% of their assets in large cap stocks AND 35% in midcap stocks. As per SEBI’s definition, the 100 largest stocks by market capitalization are classified as large cap, while the next 150 largest stocks by market capitalization are classified as midcap. According to the mandate of this category, the minimum allocation to large and midcapsin these schemes is 35% each, and the maximum can be 65% each.

How are Large and Midcap funds different from Multi-cap funds?

Previously (before SEBI’s reclassification directive), a large number of equity funds were lumped together in a relatively vague category called diversified equity funds. The problem with that classification was that different diversified equity funds had very different market cap characteristics. As a result, fair relative performance analysis was very difficult. Category reclassification has brought much more clarity for investors. However, many investors are still confused about differences between Large and Midcap funds and Multi-cap funds. There are many similarities between these two equity fund categories, but the main difference is in the restrictiveness in mandates for these two categories.

Large and Midcap funds must have minimum allocations of 35% to both large and midcap stocks. Multi-cap funds, on the other hand, have a flexible mandate; they can have any allocation to large or mid or small cap stocks, depending on the fund manager’s strategy or outlook. For example, a multi-cap fund may have an 80% allocation to large cap, but a large and midcap fund’s large cap allocation cannot exceed 65%. In a way, a large and midcap fund’s market cap characteristics are relatively more predictable than a multi-cap fund because you know the minimum allocations to different market cap segments. On the other hand, multi-cap fund managers have more flexibility to manage their schemes according to prevailing market conditions.

Variations in market cap allocations within the category

We have discussed the key difference between large and midcap funds versus multi-cap funds. However, even within the large and midcap funds category, there can be big variations in market cap characteristics between one scheme and another. This is because fund managers have the flexibility of managing their large and midcap allocations anywhere from 35% to 65% which is a fairly wide range. Therefore, investors should dig a little deeper beyond just the category classification to understand the market cap allocations of different schemes before investing, so that they are comfortable with the risk characteristics of their investment.

Variations in market cap allocations have reduced over past few months

Just after the reclassification exercise was completed by AMCs in Q2 of the current fiscal year, largeand midcap allocations of different schemes in this category were very different. Since this was a new category, AMCs reclassified both erstwhile large cap, and midcap funds into this new category. For example, an erstwhile midcap fund which used to usually have a 30% allocation to large caps, reclassified itself as a large and midcap fund by increasing its large cap allocation to 35%. Similarly, an erstwhile large cap fund which usually had 30% allocation to midcap reclassified itself to fall in this category by tinkering with the market cap allocations. It was very confusing for investors to compare funds in this category.

However, the variations in market cap characteristics have greatly reduced over the past few months and now most schemes in this category have more even balance between large and midcap stocks. As per the latest fund factsheets, large cap allocations are 50 to 60%, while mid and small cap allocations are in the range of 40 to 50%. As per Value Research, average large cap allocation for this category is around 55%, while the average midcap allocation is around 40%. Whether the reduction in variation is due to the long-term investment strategy of schemes in this category or due to the big correction in midcap stocks over the past 12 months remains to be seen since this is a new category.

Is past performance comparison relevant for this category?

If you are comparing the performance of schemes which had similar market cap characteristics for the past 3 years or so, then it remains relevant. However, you should not compare the performance of an erstwhile large cap fund in this category with an erstwhile midcap fund. If you have a large and midcap fund in your investment portfolio, you should see how it is performing versus its benchmark rather than comparing it with a fund with very different history. As stated in earlier blogs, investors should evaluate scheme performance over a sufficiently long investment horizon and not be biased by short term performance.

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Who should invest in Large and Midcap funds?

Investors with high risk appetites should invest in this category of mutual fund schemes because these schemes have a fairly significant portion of their portfolio in midcap stocks. In our view, investors should have a minimum 5-year horizon for investments in this category of schemes. Since these schemes may be quite volatile during certain times, systematic investment plan (SIP) is an excellent investment option for these schemes due to rupee cost averaging. If you have lump sum funds available, but are worried about near term volatility, you can invest in a liquid fund and use systematic transfer plan (STP) over 3 to 6 months to invest in large and midcap funds. Investors should consult their financial advisors if large and midcap equity funds are suitable for them.

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