What Makes Mid-Cap Funds A Better Choice?

Given the historical tendency for mid-cap funds to outperform large-cap funds in the long run, it’s plausible that mid-cap funds can continue their performance from this point onwards. This makes investing in mid-cap funds a good choice. The article highlights how mid-cap funds have performed and the associated risks.

Since the beginning of this year, equity indices have been on a remarkable ascent, particularly the broader equity market indices. For instance, the Nifty Mid-Cap 150 index has surged by 23 per cent year-to-date, a remarkable contrast to the single-digit returns offered by Large-Cap indices like Nifty and Sensex during the same period. Following a pendulum-like pattern, mid-cap stocks are emerging strong in FY24 after exhibiting subdued returns in the previous financial year of 2022-23. This resurgence is already evident in the past few months.[EasyDNNnews:PaidContentStart]

Historical trends reveal a recurrent pattern where mid-cap indices bounce back with superior returns after periods of subdued performance. For instance, in 2013, the Nifty Mid-Cap 150 yielded negative returns, only to generate over 50 per cent returns in the subsequent year, 2014. A similar trend was observed in 2015 and 2016, where mid-cap returns were modest, but then experienced a surge of over 50 per cent average returns in 2017. Therefore, the year 2023 is poised to be another favourable year for mid-cap investments.

The evolution of investors as mature ones in India owes much to proactive regulatory measures and the guidance provided by intermediaries. This maturity is evident in investors’ approach towards the mutual fund landscape as they gravitate towards opportunities for wealth creation. Over the last year, ending in July 2023, the number of folios, indicating unique investors in the category, has grown significantly from 94 lakhs to 1.13 crore, marking a substantial increase of around 18 lakhs or 20 per cent. This surge highlights the growing interest and participation of investors in mid-cap investments over the past year.

Better Performance
What has resulted in such increase in number of folios is definitely better performance by the mid-cap funds over different timeframes. On an average, mid cap funds have generated return of 13.89 per cent, 22.63 per cent and 8.82 per cent for three months, six months and year-till-date, respectively. This underscores the significance of mid-cap funds as they continue to demonstrate their potential for substantial returns, making them an attractive choice for investors seeking growth opportunities in the market. It is interesting to note that a couple of index funds dedicated to the mid-cap index have remained in the top quartile and beaten most of the actively managed funds.

Consistent Inflows
Such a performance has helped this category to garner more inflows. Over the past year, there has been a consistent and noteworthy inflow of investments into mid-cap funds on a monthly basis. The table reveals a pattern of healthy net inflows, indicating sustained investor confidence in these funds. Inflows have ranged from ₹1,176.31 crore in November 2022 to a peak of ₹2,151.15 crore in September 2022. There was not a single instance when the inflows dipped below ₹1,000 crore. What is heartening to note is that the flows were maximum when the market was low. This consistent trend showcases the enduring appeal of mid-cap funds among investors, highlighting their potential for growth and steady returns.

Rising AUM
The rising trend in average net assets under management (AUM) of mid-cap funds in the last one year indicates a consistent growth trajectory. The AUM has shown a steady climb from ₹174,220.03 crore in August 2022 to an impressive ₹222,719.75 crore in July 2023. This substantial increase in AUM reflects the growing investor interest and confidence in mid-cap funds. The graph below illustrates a consistent upward movement, indicating that more investors are recognising the potential of mid-cap funds as an avenue for wealth accumulation and capital appreciation. In the last one year, the average AUM of the mid-cap funds has increased by almost 60 basis points as percentage of total equity AUM. At the end of July 2023 it was at 12.5 per cent from 11.9 per cent at the end of August 2022.

What are Mid-Cap Funds?

All listed companies are categorised into three categories based on their market capitalisation by market regulator SEBI. They are large-cap, mid-cap and Small-Cap. According to SEBI, mid-cap companies are those which are ranked between 101 and 250 in the list of companies according to market capitalisation. Mid-cap funds are those that invest at least 65 per cent of the corpus in equity and equity-related instruments of mid-cap companies. The industry body of Indian mutual funds, AMFI, comes out with a list of companies in every category every six months. At the end of June 2023, the market capitalisation of the 101st company on the list was around ₹49,500 crore while the market capitalisation of the 250th company was around ₹17,400 crore.

Why Mid-Cap Funds? There are some clear reasons for being in favour of mid-cap funds. These are as follows:

1) Enhanced Returns - A pivotal driver for investor engagement is the pursuit of superior returns. Mid-cap funds emerge as a strategic channel for fulfilling this aspiration. Over the long term, mid-cap funds typically deliver superior returns compared to their large-cap counterparts. For instance, an investment of ₹1 lakh in a mid-cap fund initiated in July 2013 would now stand at an average value of approximately ₹7.13 lakhs, reflecting an annualised growth rate of 21.72 per cent. Conversely, the same investment in a dedicated large-cap fund would have amounted to around ₹4.04 lakhs, resulting in a compound annual growth rate (CAGR) of 14.9 per cent. This disparity implies an enduring outperformance of mid-cap funds over large-cap funds by a margin of 6.5 per cent per annum.

2) Managed Risk - A prevailing concept surrounding mid-cap funds revolves around their perceived riskiness and presumed heightened volatility. While individual mid-cap stocks might display increased volatility, mid-cap funds exhibit a more balanced stability when considered at the portfolio level. Assessing risk solely through the lens of standard deviation, influenced by Harry Markowitz’s portfolio theory, might not holistically portray the risk spectrum. Hence, we evaluated risk through multiple parameters and could not find very huge difference between large-cap and mid-cap funds when taken with a long-term investment horizon. When juxtaposing risk-adjusted returns, the synthesis of both risk and return data indicates that mid-cap funds typically offer superior riskadjusted returns, as evidenced by the Sharpe Ratio.

Following a period of more than 15 months of underperformance, the mid-cap category has already shown the sign of resurgence. The ongoing rebound in broader indices has propelled them to trade at historic highs. Even funds concentrated on small-cap stocks have completely rebounded from their lows. Given the historical tendency for mid-cap funds to outperform large-cap funds in the long run due to reversion to mean principles, it’s plausible that mid-cap funds can continue their performance from this point onwards.

Furthermore, the present environment is favouring the mid-cap category due to improving economic conditions. After experiencing subdued economic growth in the last few quarters, the economic landscape is rapidly approaching normalisation. Such a reversal is expected to particularly benefit mid-cap companies. While large-cap firms, often market leaders, have numerous strategies to navigate economic downturns, mid-cap companies tend to face more significant challenges during slowdowns. However, as the economy takes a positive turn and the growth rate escalates, mid-cap companies tend to flourish. Funds dedicated to mid-cap companies exhibit higher beta in relation to GDP growth – their fortunes are closely tied to economic expansion.

Presently, high-frequency growth data suggests an enduring recovery trend. July marked strong growth, and even incoming data for August showcased positive growth on a year-on-year basis. The Indian economy is showing signs of resilience in the face of headwinds from global economic slowdown and geopolitical tensions. S & P Global’s Purchasing Managers’ Index™ rose to 62.3 in July, its highest index since June 2010. The services PMI increased from 58.5 in June and remained above the 50-mark that separates growth from expansion for two years. The manufacturing PMI dipped in July, but remained above the 50-point mark, indicating expansion. GST collections have been strong in recent months, reaching a record high of ₹1.65 lakh crore in July.

These indicators suggest that the Indian economy is on track to achieve its growth target of 7.5 per cent for the current fiscal year. However, there are some risks to the outlook, including rising inflation and interest rates. The government will need to take steps to mitigate these risks in order to sustain the economic recovery. Overall, the Indian economy is in a good position to weather the current challenges.

There are two crucial factors for investors to consider before venturing into mid-cap funds. The first involves assessing your tolerance for risk, and the second revolves around the intended investment duration. Mid-cap funds tend to exhibit higher volatility compared to large-cap funds, making them unsuitable for risk-averse individuals. There are various funds within the mid-cap funds that tend to show drawdown of more than two years. Analysing the top five drawdowns of both large-cap and mid-cap funds highlights significant insights about mid-cap funds.

Firstly, the depth of correction in mid-cap funds is more pronounced than that in large-cap funds. For instance, during the 2008 global financial crisis, large-cap funds experienced an average drop of 60 per cent, while mid-cap funds faced an average loss of 73 per cent during the same period. Furthermore, the duration of decline was lengthier for mid-cap funds. In 2008, it took mid-cap funds 1,295 days to recover from the low reached on March 9, 2009, whereas large-cap funds bounced back in only 697 days. This trend persists in the current scenario as mid-cap funds have taken longer to recover from the drawdowns.

Beyond the depth and duration of decline, it’s crucial to recognise that mid-cap funds are more prone to generating negative returns within shorter timeframes compared to large-cap funds. From June 2008 to July 2023, out of a total of 2,521 instances of two years of rolling returns, mid-capdedicated funds experienced negative returns of nearly 8 per cent of the time. In contrast, large-cap-dedicated funds yielded negative returns of little more than 1 per cent of the time. Investors considering mid-cap funds must be prepared for an extended investment horizon and occasional periods of negative returns.

Moreover, for investors aligning funds with their goals, mid-cap funds suit long-term objectives. If the goal horizon spans more than seven years, mid-cap funds may be suitable, while shorter timeframes might not be conducive for these funds. Additionally, mid-cap funds should constitute a portion of ‘satellite’ holdings, typically around 30-35 per cent of the portfolio, based on age and risk appetite.

Mid-cap funds offer better growth potential as compared to large-cap funds and have lower volatility in comparison with small-cap funds. In a long-term portfolio, these can serve as a good diversification tool and can add growth components to the portfolio. There were 29 active mid-cap funds options available for investors at the end of July 2023. Different funds would be suitable for different investor personalities and so what is the best strategy to select mid-cap fund? Broadly speaking, there are two categories of mid-cap funds that are available to an investor – active funds and passive funds represented by the index funds.

When an investor invests in mid-cap indices the risk of selecting a fund that underperforms the benchmark gets reduced significantly. Also, the returns offered by the mid-cap index and passively managed funds have been better than the actively managed funds in the recent period. For example, year-till-date the mid-cap index has yielded return of approximately 23 per cent, better than 90 per cent of the actively managed funds’ return in the same period.

Mid-cap funds can be a good investment avenue for investors looking for growth potential and diversification. But, there are certain risks associated with these funds and you should carefully consider the investment goals and risk tolerance before investing.

Nonetheless, it should not be construed that passively managed funds are better than actively managed funds in the mid-cap category. It is only a point of reference for gauging the performance and you should check the return through different periods. The following points highlight how to select the right mid-cap fund and can be applied to other categories of mutual funds too. 

∎ Steady Performer - Prioritise funds that consistently rank within the first or second quartile of their category, outperforming both peers and benchmarks consistently. You can also use the rolling returns of different timeframes to understand the consistency in the performance of the fund.
∎ Resilience in Downturns - Funds that exhibit resilience during market downturns or effectively curtail losses often exhibit strong long-term performance. Among various ratios, the capture ratio holds significant importance. This metric gauges a fund’s performance during both upward and downward market movements. It offers valuable insights into the risk management skills of a fund manager – a critical consideration for mid-cap funds given their higher risk profile compared to large-cap funds. Additionally, it assesses the fund manager’s stock selection abilities across market fluctuations, a crucial aspect for mid-cap funds known for deviating from market index trends.
∎ AUM Size - The fund’s assets under management (AUM) can influence liquidity and trading volumes. While higher AUM can boost liquidity, excessive AUM might negatively impact performance. You should opt for funds with AUM around the category median.
∎ Track Record - Longer fund history indicates endurance across various market cycles. Prefer funds with substantial track records, reflecting their ability to weather economic shifts.
∎ Expense Efficiency - Lower expense ratios often correlate with better fund performance. Select funds with comparatively lower expense ratios among their peers.
∎ Reputed Fund House - Choose funds managed by established asset management firms with proficient in-house research teams. Robust portfolios are built by fund houses with comprehensive coverage and adept portfolio construction techniques.

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