Present any portfolio without a mid-cap or small-cap fund and investors pass judgement very quickly. It is too conservative, it is missing return opportunities, it is large-cap biased and so on.
It’s the natural conclusion to reach, as mid-cap and small-cap exposures are usually added in a portfolio to add to its return potential. But the category a fund belongs to and the stocks it actually owns, are two different things. There are several ways to add a mid-cap or small-cap exposure to your mutual fund portfolio without going for the traditional mid-cap and small-cap fund route. Here’s how.
Different routes to mid-and-smallcaps
There are 3 categories that are dedicated to a single marketcap segment – the largecap category, midcap category and smallcap category. Largecap funds are mandated to hold at least 80% in largecap stocks, while midcap and smallcap funds must hold at least 65% in midcap stocks and smallcap stocks respectively.
This clean structure means that these categories are straightforward in what they do. Comparison within the category is easy, benchmarks are standard. Therefore, midcap and smallcap funds are commonly used to add high-return options to a portfolio.
The remaining fund categories can be split into three broad groups:
- Discretion to move across market caps: These are the flexicap, focused, value, contra, and dividend yield categories.
- Mandated allocation to marketcap segments: These are the large-and-midcap category, where minimum midcap exposure needs to be 35%, and the multicap category which needs to have a minimum of 25% each in smallcaps, midcaps, and largecaps.
- Thematic and sectoral: These are concentrated in a particular sector or theme, but move across market caps to play the theme.
The tables below show the average allocation to the midcap and smallcap segments across fund categories over the past few months.
As the data shows, opportunities to invest in midcap stocks can exist in categories outside of the midcap fund basket. Based on AUM, in fact, fund categories other than the midcap category actually account for as much as 64% of the aggregate exposure to midcap stocks held by equity funds. The large-and-midcap category alone, for example, accounted for 15% of the total midcap exposure. Flexicap funds accounted for about 9.5% of total midcap exposure.
Similarly, in smallcaps, 60% of the total smallcap exposure sits outside the dedicated smallcap fund category. The multicap category held about 9% of the total smallcap exposure, and the flexicap category holds 8%.
All this goes to show that there are several ways to mix and match equity categories to bring in high-return, higher-risk funds even without owning dedicated small-cap and midcap categories.
Shaping the risk-return balance
Constructing a portfolio out of a variety of fund categories, rather than relying only on the vanilla marketcap segments can help in more nuanced portfolio construction. This allows you to tailor fund allocations to suit your desired risk level and marketcap composition.
Take a look at the two portfolios below. Both were portfolio recommendations in our earlier Prime Portfolios (under our Research Analyst service).
- Portfolio 1 has no small-cap fund. However, both the Nifty 500 index and Kotak Midcap have a reasonable smallcap allocations and this provides the portfolio with an 8% exposure to smallcap stocks.
- Portfolio 2 is a more aggressive portfolio meant for high-risk investors. in this portfolio, there is no dedicated midcap exposure. Even so, between the Nifty 500 index, Invesco India Contra, and HDFC Pharma the midcap allocation is sizeable. As a proportion of the overall equity exposure in this portfolio, midcaps account for close to 22%. This apart, the thematic fund adds a higher-return component to the portfolio, as does the high smallcap allocation. A pure midcap fund, therefore, is not really necessary.
There are several such ways in you can mix different categories to access segments across the marketcap curve and to adjust the overall risk level and return potential of the portfolio to your liking. Since categories such as multi-cap and large-and-midcap especially have standard allocations, it is easier to work out what the overall portfolio weights to market segments would be.
For example, take Portfolio 2. If you were a more moderate risk investor, you could tweak Portfolio 2 to remove the pure Nippon India Smallcap and replace it with a multicap fund. This would still give you exposure to the smallcap space but without the higher risk. Or take Portfolio 1 – if you wanted some more midcap exposure without upping the risk too much, you could replace the large-cap fund with a large-and-midcap fund.
Our Prime Vision mutual fund PMS portfolios are designed in this manner to combine multiple categories and balance the risk and return of the overall portfolio, without going on the standard track of largecap-midcap-smallcap categories.
Fund-wise differences
Individual funds within a category can also diverge a lot from the average of the category. This is true especially in the focused and flexicap categories, where there is more discretion on where a fund can go.
Consider Bandhan Focused Fund. The smallcap allocation it has had in the past few months is about 30-40%. But the average for the category itself is 14%. There are funds such as Axis Focused, Aditya Birla Focused, or Kotak Focused all of which have little to no smallcap holdings. Similarly, in the flexicap category, the average midcap exposure is 20%, but one in every four funds holds over 25% in midcaps.
Therefore, an aggressive fund can be tucked away in what you may otherwise think is a moderate or conservative category. If you focus only on the headline categories, you may be missing out on more suitable options.
Takeaways
You can use the following basic guidelines when trying to manage the return-risk balance in your portfolio:
- The primary categories to add mid-and-smallcap stock exposure are the two dedicated categories of midcap funds and smallcap funds.
- The multicap category can be used for both midcap and smallcap exposure. This category is lower in risk profile and will obviously deliver lower returns. But you can use this category to add such exposure to your portfolio without disproportionately increasing the risk.
- The large-and-midcap category can be used to add a midcap tilt to a portfolio. This is especially useful if you have a high weight to a smallcap fund in your portfolio. Adding a pure midcap would substantially increase the total risk. If you would like to temper the risk, a large-and-midcap fund can provide the necessary allocation.
- With flexicap and focused funds, don’t assume that they are conservatively managed. Always look at the fund’s portfolio to determine where it invests in order to understand its marketcap profile.
- The flexicap, focused, and large-and-midcap categories can also be used by aggressive investors to add large-cap exposure in portfolios. If you are doing this, bear in mind that these funds are well above pure largecap funds in risk profile.
- If you have a good thematic exposure in your portfolio, remember that this already adds risk and return. You may not, then, need a dedicated smallcap or midcap fund. You can use other categories such as multicap or large-and-midcap for such exposure.
Our mutual fund screener offers a break-down of portfolio-level allocations across marketcaps. You can use this tool to run screeners across funds. The individual mutual fund pages also provide these marketcap breaks ups for you to understand what your fund actually holds.
The point is not that you should avoid midcap and smallcap funds. It is that a portfolio without them isn’t automatically a low-risk, low-return portfolio. The only way to know what you actually hold is to look at the fund’s portfolio and not simply go by its label.
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