Why You Should Choose Large-Cap Funds Over Mid-Cap and Small-Cap Funds Now

All three indices, despite bouts of volatility and corrections in the interim, have displayed notable upward trends backed by earnings and created well for investors.

In CY 2024 and even in the previous calendar year, the smallcaps have demonstrated the most significant growth, outperforming both midcaps and the largecaps. In other words, the smaller companies have displayed the potential to deliver exceptional returns.

However, the Indian equity market has been defined by volatility and of late it has intensified, making investors more vulnerable to downside risks associated with midcap and smallcaps.

[Read: The Key Factors Behind the Recent Volatility in the Indian Equity Market]

Until now while some Small Cap Funds and Mid Cap Funds have clocked spectacular returns, it is not necessary that the historical returns would prove indicative of the future expected returns.

In fact, compared to large-cap counterparts, Small Cap Funds and Mid Cap Funds would be more susceptible to market fluctuations. It is essential to understand that Mid Cap and Small Cap Mutual Funds often experience sharper price swings, thereby increasing the risk of loss.

The Indian equities currently look frothy in terms of valuation, as evident from the current P/E ratios (calculated by dividing the Market Price by the Earnings):

It is clear that Indian equities, particularly midcaps and smallcaps, are commanding a premium compared to emerging and global markets. These levels appear stretched, even after a nearly 11% market correction since the September 2024 peak (as of January 20, 2025).

The margin of safety particularly in the midcap and smallcap segments of the Indian equity market currently does not seem comforting. Notably, if the market corrects from hereon for whatever reason, the correction can be more pronounced in the smallcaps and midcaps.

Adding to this caution is India's market capitalisation-to-GDP ratio -- famously referred to as the Buffett Indicator (after the legendary investor Warren Buffett). Following a recent 10-year high of 139.36%, this metric currently stands at 113.96%, placing the Indian markets in the 'modestly overvalued' territory.

That being said, it is not the case that the entire market is expensive; in certain pockets, one can still find value.

At present, the valuations in largecaps are more comforting than the midcap and smallcap counterparts, if not exactly inexpensive, with the Nifty 100 P/E ratio standing at 22.31 (as of December 31, 2024).

The Headwinds for the Indian Equity Market

The Indian equity market faces headwinds or risks from multiple global and domestic quarters, which could further impact mid-cap and small-cap stocks. The key risks are...

• Geopolitical tensions (Given that U.S. President Donald Trump would be following protectionist policies to 'Make America Great Again', there are trade tensions between the U.S. and China, ongoing military conflict between Russia and Ukraine, tensions in the Middle East, etc.)

• Chances of geoeconomic fragmentation and capital outflows

• Concern of inflation going up due to higher tariffs being imposed and supply chain issue

• Diminishing hopes of the U.S. Fed rate cuts

• Weak Indian Rupee (INR) against the greenback

• Extreme climate events and cyber risks

• Chances of slowdown in global GDP growth

The RBI's recent survey has shown that geopolitical conflicts, the evolution of global growth and inflation, and capital outflows/rupee depreciation as major near-term risks.

Another factor, and an important one that would weigh on the markets is disappointing corporate earnings from India Inc. of late.

While India's corporate earnings were encouraging post-pandemic (the past 4 years), with a profit-to-GDP ratio of 5.2% in FY24, the Q2FY25 reveals a slowdown. In contrast in the U.S., corporate earnings of several S&P 500 companies have been quite encouraging.

Factors such as declining consumption or demand and rising expenses or input costs are weighing on topline and bottom-line performance, reflecting a cyclical downturn of India Inc.'s corporate earnings. Seeing the reality, earnings downgrades cannot be ruled out.

Given that the valuations of midcaps and smallcaps do not offer comfort (as seen in Table 1), these segments could experience a sharper downward trend if earnings do not live up to the expectations and the market corrects further.

Considering the current volatile environment, having a higher allocation to some of the best Large Cap Funds as part of the core portfolio is a sensible move now. These funds offer relative stability compared to the higher risks associated with mid-cap and small-cap funds.

If you have a high-risk appetite, but you're not a very aggressive investor and have an investment horizon of around 5 years or more, allocating a dominant portion -- around 60% to 65% -- of your investment portfolio to carefully selected large-cap mutual funds may be a meaningful strategy.

The advantages of owning some of the best Large Cap Funds as a part of your core portfolio are...

• Experienced fund managers make well-informed investment decisions on behalf of you, the investor.

• Large-cap funds expose you to financially sound, well-established companies with strong fundamentals.

• They tend to offer relatively stable returns and steady growth over the long term, with lesser risk compared to mid-caps and small-caps.

• During economic slowdowns, large-cap funds tend to experience lesser downside risk compared to their mid-cap and small-cap counterparts.

• These funds offer high liquidity, allowing for easier exits if necessary.

To diversify your portfolio, you may also consider including the best Value Funds/Contra Funds and Flexi-cap Funds as part of the core portion.

At present, only if you have a very, very high-risk appetite and have an investment horizon of 7-8 years or more, you may hold one or two best Mid Cap Funds in the satellite portfolio of the portion of the portfolio that have the potential to outperform large-cap funds over the long term. If you are already holding some of the best Midcap Funds only, avoid making fresh investments now.

Small Cap Funds can be avoided now for fresh investments as valuations aren't very comforting currently.

The key is to avoid overexposure to these riskier assets and ensure that their allocation aligns with your risk tolerance.

"The essence of investment management is the management of risks, not the management of returns." - Benjamin Graham (the father of value investing and Buffett's mentor).

For tactical asset allocation that balances equity, debt, and gold, a multi-asset fund could also be an excellent choice, offering diversified exposure across asset classes.

Should You Go with Lump Sum Investments or SIPs?

In light of the current challenges and market volatility, it is prudent for investors to adopt a cautious approach when making fresh investments.

Instead of deploying the entire investible surplus at once, a staggered lump sum investment strategy could be a more effective way to navigate market uncertainties. You could use significant market dips to deploy the investible surplus in a staggered lump sum manner.

For most investors, however, Systematic Investment Plans (SIPs) remain the best way to navigate volatile markets, especially when addressing long-term financial goals like buying a home or planning for retirement.

SIPs encourage disciplined investing, help average out the cost of investments over time and reduce the impact of short-term market fluctuations with the inherent feature of rupee-cost averaging while allowing the power of compounding to work in your favour over the long term.

Alternatively, you could consider a Systematic Transfer Plan (STP). This approach typically involves first parking funds in a liquid fund and then systematically transferring amounts into one of the carefully chosen, best equity funds.

Doing so helps reduce the risks associated with trying to time the market and ensures a smoother, gradual transition into equities.

Ultimately, the decision between lump sum investing and SIPs depends on the market factors, your specific financial goals, and the time horizon for achieving those goals.

To Conclude...

Making fresh investments in Mid Cap Funds and Small Cap Funds could be rather risky now when the Indian equity market is likely to be quite volatile.

While these segments have delivered impressive returns in recent years, no point in getting swayed by past performance, as it is not a reliable indicator of future results.

Given the stretched valuations in midcap and smallcap stocks compared to largecaps, the downside risk for these segments is significantly higher if the market undergoes further corrections. On the other hand, large-cap funds could offer relative stability and better downside protection.

To navigate the current market landscape effectively, make sure your portfolio is well-diversified and rebalanced keeping your risk-reward in mind.

Carefully select mutual funds that align with your investment objective, risk tolerance, the financial goals you wish to address and the time horizon to avoid undue risks.

A thoughtful and disciplined investment approach shall pave to path to financial success and achieving the envisioned goals.

Happy investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.