Navigating the mid-cap maze: Can investors bite the short-term bullet?

All three segments — mid-caps, small-caps, and micro-caps — are currently trading at significantly higher valuations, not only compared to large-caps but also relative to their historical valuation trends. This situation has raised concerns, prompting regulatory bodies to intervene. Earlier this year, the Securities and Exchange Board of India (SEBI) urged investors to remain cautious and not be swayed by recent performance.

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To enhance transparency, SEBI mandated that asset management companies (AMCs) conduct stress tests for mid-cap and small-cap funds. Starting March 2024, AMCs are required to disclose the results of these stress tests monthly, providing investors with a clearer understanding of the risk profiles associated with their investments. These results have to be published on both the AMCs' websites and the Association of Mutual Funds in India (AMFI) website within 15 days after the end of each month.

The disclosure format, agreed upon by AMFI and SEBI, will include several critical metrics. These will encompass the annualised standard deviation for both the scheme portfolio and its benchmark index, as well as the trailing 12-month price-to-earnings (PE) ratio for both. Additionally, the portfolio beta will be reported, offering insights into the scheme's risk relative to the broader market. The disclosure will also detail portfolio turnover, indicating how frequently assets within the scheme are traded. Furthermore, AMCs will assess portfolio liquidity under stress scenarios, determining the time required to liquidate 25 percent and 50 percent of the portfolio in the event of a market downturn.

Is mid-cap investing necessary?

Mid-cap mutual funds run an investment objective of investing in mid-cap companies that in the Indian context are defined as those that invest at least 65 percent of the corpus in companies ranked between 101 and 250 by market capitalisation.

Mid-cap companies represent a unique segment of the equity market that often exhibits strong growth potential. These companies are usually in a phase of expansion, benefiting from increased market share and operational efficiencies. Unlike large-cap companies, which may have already saturated their markets or offer lesser potential of growth, mid-cap firms often have more room to grow, making them attractive to investors seeking capital appreciation.

Their agility allows them to adapt quickly to changing market conditions, innovate, and capitalise on emerging trends, positioning them well for future success.

Investing in mid-cap funds can provide a diversified approach to capturing the growth potential of these companies. Mid-cap funds typically invest in a basket of mid-sized companies, which helps mitigate the risks associated with investing in individual stocks. This diversification can lead to a more stable investment experience while still offering the opportunity for significant returns.

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The strong potential of midcap companies and funds is further supported by historical performance trends. Over the long term, mid-cap stocks have often outperformed both large-cap and small-cap stocks, driven by their ability to scale and innovate (Nifty Midcap 150 has delivered 20.6 percent per annum over a 10-year period versus 14 percent by Nifty 100 and 17.8 percent by Nifty Smallcap 250 as of August 2024. Furthermore, mid-cap funds often have lower volatility compared to small-cap funds, making them an appealing option for investors who want exposure to growth without the heightened risks that can accompany smaller companies.

Active or passive mid-caps: which works better?

Moving further for investors who have decided to embark on their journey into mid-cap funds, it is essential to consider the ongoing debate between passive and active fund management. While mid-caps present significant growth potential, it is important to recognise that many active mid-cap funds have historically struggled with underperformance.

Understanding the factors contributing to this trend is crucial, as it may reveal potential aspects that investors should be aware of. By evaluating these aspects, investors can make more informed decisions about their mid-cap investments and understand the merit in the underperformance by some active managers.

• Higher expense ratio relative to index funds.

• Market efficiency: With more and more inflows to midcap stocks over the last 7-8 years, market efficiency within midcaps has improved a lot. This means that there is less room for active managers to find mispriced stocks and generate alpha.

• Higher tracking error: Active managers might deviate more from their benchmark, and these deviations can lead to underperformance.

• Active managers are more selective: When it comes to mid and small-cap investing, actively managed mid-cap funds aim to select high-quality stocks based on rigorous analysis. This can result in holding stocks with superior growth potential or financial stability compared to some of the lower-quality constituents in the index.

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• Size - Large mid-cap funds can face difficulties deploying significant amounts of capital into mid-cap stocks due to limited liquidity. When a fund grows too large, it may struggle to invest efficiently in smaller, less liquid mid-cap stocks without moving the market or impacting stock prices adversely.

Large inflows can force a fund to buy large positions in mid-cap stocks, potentially driving up prices and reducing the potential for returns. Conversely, large outflows can lead to forced selling, which can negatively impact the fund's performance.