Morningstar: Why you should invest in mid, small cap funds

Shares of mid and small cap companies, by virtue of their higher growth potential, can offer outsized returns compared to their large cap peers but they can also serve as a minefield for investors.To invest in such stocks, investors who do not have the time, inclination or understanding should look to hire the services of a professional fund manager.In an interview with CNBC-TV18, Kaustubh Belapurkar, Director - Manager Research, Morningstar India, said good mid and small cap funds can deliver returns much more than their underlying benchmarks."For those who want long-term wealth creation, such funds should certainly be a part of investors' portfolio," he said.Belapurkar, however, said that such funds can also be volatile and that they should complement large cap funds in the portfolio and a long term horizon is a must.Below is the verbatim transcript of Kaustubh Belapurkar's interview with Anuj Singhal and Ekta Batra on CNBC-TV18.Anuj: 40 percent compounded annual growth rate (CAGR) over the last three years in some of the best midcap funds?A: If you look at the way the industries themselves have moved versus the largecap category, you have had anywhere between 20 percent and 22 percent in the midcap and the smallcap index on the BSE. However, what is crucial to understand is the fund because the dispersion of returns on the midcap and the smallcap side is so huge, the good active fund managers can deliver significant alpha over the benchmark. That is where lot of these good fund managers have outperformed the index by 10-15 percent on a consistent basis over the last three-five years and that is where investor should be looking at. They are more volatile than your largecaps but if you are looking at long-term wealth creation, this should certainly be a part of your portfolio.Anuj: Let us talk about the one which has been the clear outperformer, the DSP Blackrock Microcap Fund. 40 percent CAGR over three years, what stands out here and if you can tell us a bit about the fund manager as well?A: The microcap fund is positioned in sort of the smallcap or the microcap fund universe from the DSP's stable. What it is looking to do is invest predominantly into the smallcap segment, market capitalisation of less than Rs 3,000 crore and the way he has been managing, it is a pure buy and hold strategy. So Vinit Sambre who is a fund manager, has been doing this for the last six-seven years and once he has gotten to that whole buy and hold play, he can ride that market wave. That is where he has delivered that significant outperformance over the smallcap or some of his midcap peers, so clearly the buy and hold strategy is working well for him and that is where he could derive the returns from.Ekta: What about Franklin India Prima, one of the stocks that stands out as Yes Bank?A: Franklin is more investing in to the larger midcap plays. So Janakiraman R, who is the manager, he is the midcap specialist at Templeton. They have an excellent team backing him up in terms of analysts. What is important to understand is when you go down to the smaller capitalisation space, there is not enough sale side research coverage or adequate if I may say so. So it is where the resources of the asset manager come in in terms of packing that up with good quality research and coming up with ideas where you can invest into. So Franklin has got an excellent team set up in terms of the analysts, the manager double up as analysts. That is where the strength of the Templeton guys lies.What is important to understand is where has he derived his returns from. So some of the stocks that have stood out and which he has identified early, so be it Amara Raja Batteries, Finolex Cables, Torrent a little more larger sort of capitalisation stock but these are some of the ideas that have done well for a manager like him.The other thing that this manager does is not only does he play the growth story but he also looks at certain names, which could be potentially beaten down stocks, and he could add of slightly better flavoured value in the portfolio and he gets an excellent overall return on his portfolio.Anuj: Hindsight is 2020, we can say that with some of the best performing funds but in general do you get a sense that the midcap and smallcap funds have returned better value for investors as a category compared to the largecap and the Nifty itself?A: The way I would see it is that largecaps are a crucial holding of any investor's portfolio. Midcaps are what you would call the real growth engine to an investor's portfolio depending on the risk profile, you should look at what allocations you should make to the midcap space.Yes, they have delivered significant returns over the last three-five years compared to largecap funds but you have to be wary that they are more volatile. So you clearly need to have a long-term horizon in terms of investing in some of these funds. So, I will say even 5-7 years might be a short time because you can have cycles in the market where midcaps might underperform and since they have run up so much, you have to be a little cautious when entering this segment.