Should you go passive in the mid- and small-cap fund space just like in large-caps?

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Passive investing has gained traction in India, particularly in the past two years, evident from the number of index schemes rolled out by fund houses in the equity space.

India has 85 index funds, of which more than half (nearly 57 percent) have been launched only in the past two years since January 2021.

Nearly 38 percent of the new index funds were in the large-cap category. Almost every fund house already has one index fund in the large-cap category; many passive funds are now being launched in the mid- and small-cap space.

Should investors invest in these too and build a complete portfolio of passive funds? The choice between active and passively managed funds primarily boils down to one thing -- whether actively managed funds can beat their benchmarks and give additional risk-adjusted returns to investors. Let us reflect on some data.

After the recategorization since 2018 by the Securities and Exchange Board of India (SEBI), the top 100 stocks in terms of market capitalisation are classified as large-cap stocks, 101-250 as midcaps and from 251 onward as small caps.

With the restricted choice of just 100 companies in the large-cap universe, fund managers are finding it hard to beat the markets.

Data sourced from Morningstar for the 3- and 5-year rolling periods show that as of 29 November, 2022, only 15 and 12 percent of the active large cap funds could beat their benchmarks, respectively.

In the mid-cap category for the 3-year rolling period, the number of active funds outperforming their benchmarks went up to 30 percent and to 43 percent for the 5-year rolling period. The difference is wider in the small-cap category. Nearly 43 percent of the active small caps outperformed their benchmark over 3 years while 86 percent beat their benchmarks over 5 years.

Even the margin of difference in outperformance in the three categories is stark. The difference in average rolling returns for the few large cap outperformers vis-a-vis their benchmarks was in the range of an average 70-150 basis points. On the other hand, mid-caps and more particularly small caps have outperformed their benchmarks by a huge margin of a minimum 200-250 basis points.

One basis point is one-hundredth of a percentage point.

For large caps, a lot of information is publicly available as they are widely tracked unlike in the case of midcaps and more so for small caps. A recent news report said one in every seven small caps on the National Stock Exchange has either been suspended or delisted in the last five years.

If you compare the constituents of the Nifty Smallcap 250 Index of 2019 with the present one, nearly half the companies have been replaced in three years. Research to pick fundamentally solid companies plays a crucial role and this is where a fund manager’s stockpicking skills come into play.

Also, the average difference in expense ratio between active and passive funds in the mid- and small-cap space is under 50-70 basis points. This is not substantial enough and is easily being compensated with the huge margin of outperformance by the active funds.

The passive mutual fund industry (Exchange-Traded Funds and Index Funds) is growing by leaps and bounds. At the end of October 2022, their Assets Under Management roughly constituted 11 percent (Rs 4.38 lakh crore) of the total assets of the mutual fund industry (Rs.39.53 lakh crore).

There are limited passive products in the mid- and small-cap categories. In the passively managed ETF category, there are just five midcap ETFs and none in the small-cap space. In the index category, there are 11 midcaps and 7 small-cap passive funds out of the total 85 Index Funds.

As markets deepen over time, we can expect new product launches in this segment. Tracking error data will be an interesting piece of information to watch out for in these two categories. It is the annualised standard deviation of the difference in daily returns between the underlying equity index and the Net Asset Value (NAV) of the ETF/index fund, based on the past one year’s rolling return data. SEBI has mandated publishing tracking error data regularly by fund houses and it should not be more than 2 per cent.

As of now, it appears fund managers have a lot of scope to generate alpha for investors in the active mid- and small-cap fund categories. Investors can allocate mid- and small-cap funds in portfolios in line with their risk appetite and can seek investment advice of a professional adviser on this.