Can A Long Term Investor Improve Their Return By Investing In Mid/Small Caps?

(December 24, 2018: This article is no longer current. With the introduction of standardised mutual fund categories, fund mandates have become more specific and some portfolios will require specific allocation to mid caps.)

With the dramatic performance of the stock market in 2014, several people have asked us questions about the following theme:

• What is the expected long term return from stocks markets, and
• If one should invest in small/mid cap mutual funds to improve returns.

The answer, as always, lies in historical trends and the following analysis should help you arrive at some conclusions. The table below shows the annual performance of various Indices, which cover Large caps, Diversified and Mid Caps. These are well published and widely followed Indices, and therefore a good basis to start out analysis.

From the above table, we can observe the following.

1. Over the past decade, almost all the Indices have delivered annual returns in the range of 14-15% pa.

• This is in line with the nominal GDP growth and in line with long term expected returns from equities in India.
• This also converges with corporate revenue growth (for the large cap companies), which is in the range of 15-17% pa

1. Contrary to conventional wisdom, the returns for large cap, diversified and mid cap indices converge to about 15% pa over the long term.
2. As expected, volatility of the Mid-cap Index is higher than the Large cap and Diversified Indices.
3. The Mid-cap Index seems to perform better than the Large cap & Diversified indices in good years and worse in bad years.

What should an investor do ?

1. Data over the past decade (above) suggests that long term investors may not benefit significantly by investing in Mid caps over Large caps or Diversified portfolios. On the other hand, if you can ‘time’ your entry and exit well, you may be able to take advantage of the high positive returns in Mid caps in the good years.
2. Besides the obvious difficulty of ‘timing’ the market, tax on short term capital gains could significantly reduce your return and must be taken into account.
3. It is, therefore, better to select diversified mutual funds that have a flexibility to move between large and midcaps, and select fund managers who have best handled the portfolio allocation.
4. Note that if the fund manager manages the allocation between Large and Mid/small caps, and if the investor holds the fund for >1 year, there is no tax impact.

At Scripbox, in line with the above thinking, we believe that it is better to select diversified funds which have best managed portfolio allocation between large and midcaps across different market conditions.

Note : Among the Scripbox portfolio of equity funds, only 52% of stocks, by portfolio weight, is in Sensex stocks and the balance is a mix of mid and large caps.