Those of you who have attempted to research mutual funds may have felt overwhelmed with the hundred different types of mutual fund categories; it is easy to get lost in the jargon.

Based on the market-cap focus of the fund, you have large-cap funds, mid-cap funds, multi-caps, micro-caps, flexi-caps, and so on. The investment style further classifies the funds as value, growth, blended or opportunity funds.  If you are new to the investment world, these names could leave you baffled.

For newbies, “Market cap” short for “Market Capitalisation”, refers to the size of a company, calculated by multiplying its current stock price by the number of shares outstanding. Based on this size, stocks are generally classified as large-caps, mid-caps, and small-caps. (Some market participants, breakdown the list further to include mega-caps and micro-caps at the extremes.)

Mutual funds that predominantly invest in a predefined market-cap of stocks are categorised accordingly. So a large-cap fund, also known as a blue-chip fund, will primarily invest in large-cap stocks, while a multi-cap or flexi-cap will invest in a mix of large-cap and mid-cap stocks. In this article, we will focus on large-cap funds and mid-cap funds.

Blue-chip Funds Vs Emerging Blue-chip Funds: The primary difference

Blue-chip funds invest in large companies with large businesses. The products or services of these businesses are well known and widely accepted. Hence, these companies earn a stable profit and pay out regular dividends. These mature businesses are less volatile and deliver a stable return over the long-term. Some well-known blue-chips are Tata Motors, Infosys, HDFC Bank, ITC, etc.
 

Blue-chips
✔ Established business models	✘ Reduced flexibility
✔ Low Risk	✘ Lower return potential
✔ Highly liquid

Mid-cap funds, also referred to as emerging blue-chip funds, predominantly invest in mid-cap stocks. Such stocks have the potential to grow at a much faster rate than large-caps. The prices of some mid-cap stocks might not reflect their true value yet, and so, they offer the potential of higher returns over the long-term. But as some businesses lack financial stability, the returns can be volatile. Some better-known mid-caps are Just Dial, DCB Bank, IPCA Laboratories, etc.
 

Emerging Blue-chips
✔ Evolving business	✘ Prone to high risks
✔ Business in the high growth phase	✘ Can be illiquid in a volatile market
✔ Superior return potential

Portfolio allocation

Every scheme in its offer document, predefines its asset allocation. Here, the definition of large-caps can vary from fund to fund. More diversified funds may define their large-cap bucket as those stocks that have a market-cap higher than the lowest market-cap stock in the S&P BSE 100 index. More convergent funds may restrict their large-cap selection to stocks that have a higher market-cap than the lowest market-cap stock on the Nifty 50.

Most emerging blue-chip funds define mid-caps as those companies having a market cap between the highest market-cap stock and lowest market-cap stock on the BSE Mid-Cap Index or the Nifty Free Float Mid-cap 100 index. Such funds also allow an allocation of up to 25%-30% to large-cap stocks.

The investment strategy of some large-cap funds may allow a strategic allocation to mid-caps as well. Here, fund managers may invest upto 30% of the portfolio in stocks outside the large-cap bucket. This enables them to invest in mid-caps based on market outlook. The funds can use this allocation to add stability to the portfolio in volatile market conditions.

Risk measures

Investing in smaller mid-sized companies is riskier than investing in larger companies. Quite logically, smaller companies don’t have the financial resources of many larger companies to weather a financial storm. Their products or services are often still unproven. Therefore, when the economy goes through a rough patch, smaller businesses crumble first.

Let’s quantify the risk of the two fund categories over the past three years. The results can be seen in the table below:
  Risk Measures of Large-cap Funds and Mid-cap Funds  

	Beta	Standard Deviation
Large-cap Funds	1.00	15.45
Mid-cap Funds	1.11	18.42

Data as on May 19, 2017
*Risk is measured by Standard Deviation and Downside risk is measured by Sortino. They are calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a.) (S&P BSE 200 is taken as the default benchmark index while calculating the ratios for all funds)
(Source: ACE MF ,PersonalFN Research)

Clearly, returns of mid-cap funds are riskier than large-cap funds. The risk, as measured by standard deviation, is higher for mid-caps. The higher beta of mid-cap funds signifies that the returns of funds are more volatile than the benchmark. A Beta of 1 unit, tells us that the volatility of large-caps was in line with the broad market S&P BSE 200 index.

Therefore, if you plan to invest in a mid-cap fund, be prepared for high volatility over the short term.

Long-term return potential

Though mid-caps may be volatile over the short term, they have the potential to deliver high returns over the long term. Over a 10 year period, mid-cap funds delivered an average compounded return of approximately 14% , compared to 11% delivered by the large-cap fund category. So if you had invested Rs 1 lakh a decade ago, under an average mid-cap fund, the investment would have been worth Rs3.70 lakh today. The average large-cap fund would have grown your investment to Rs 2.75 lakh.

When the returns are compared over different market cycles, we can clearly see that mid-caps outperform large-caps in bull phases, but lag their peer in the bear phases. Large-caps too, deliver a decent return, but are not as extravagant as those that mid-caps delivered. Blue-chip funds are more stable, and this enables them to curb the downside. In speculative, liquidity-driven periods like the ongoing market rally, mid-caps perform well.
  Performance Across Market Cycles

Fund Category	10 Years	08/Jan/08 To 09/Mar/09	09/Mar/09 To 05/Nov/10	05/Nov/10 To 20/Dec/11	20/Dec/11 To 03/Mar/15	03/Mar/15 To 25/Feb/16	25/Feb/16 To 19/May/17
Large-cap	10.65	-53.08	76.43	-24.16	26.22	-20.84	31.46
Mid-cap	13.99	-64.58	104.49	-27.71	37.93	-16.32	40.61
Benchmark
S&P BSE 100	8.58	-58.048	80.99	-27.15	24.39	-22.57	30.25
S&P BSE Mid-Cap	9.10	-68.46	108.94	-37.97	27.61	-13.87	41.62

Data as on May 19, 2017 Returns over 1-Yr are compounded annualised
(Source: ACE MF, PersonalFN Research)

Which one to opt for?

Choosing the right fund should be a factor of your age, risk tolerance, investment horizon, etc. Both blue-chip funds and emerging blue-chip funds are essential for your portfolio. While large-caps offer stability for your portfolio, mid-caps come with the potential of generating supernormal returns over long term.

It’s difficult to know when the market will favour large-cap or mid-cap stocks, it’s a good idea to include a mix of different fund categories in your portfolio. An investor with a shorter time horizon, who is looking for lesser volatile returns or for funds that will provide more stable returns, may want to hold a higher allocation of large-cap funds.

Do not get carried away with mid-caps delivering stellar returns over the past few years. Generally, the younger you are, the more investible surplus can be allocated to mid-cap funds.  You'll be able to tolerate more risk and have years to invest. Keeping in mind the portfolio allocation is the key. You can appoint a financial planner to suggest the best asset allocation to achieve your financial goals.

Before committing to a fund, step back and consider the big picture. Check how it performed over the past five years? What about over different market cycles? How has it managed risk? Look for mutual funds that stand the test of time and continue to deliver strong long-term returns.

A Certified Financial Guardian – who is a mark of trust and respect, can help you determine which mutual funds line up with your objectives.

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