Mid cap funds? Think long-term

The recent stock market crash has been particularly harsh on one investment category -- mid cap stocks/funds. Compared to their large cap peers, mid cap stocks/funds have fallen more sharply. The view that many frustrated investors might take is that investing in mid caps was a bad idea in the first place. And they can't really be blamed, in many ways mid caps were presented as an opportunity to make quick money without informing the investor of the higher risk involved.

At Personalfn, we have a different view on mid caps. There is no doubt that if identified correctly, mid caps can contribute significantly to an investor's wealth. For investors, there is merit in including mid cap stocks/funds in their portfolios; the allocations will vary depending on their risk appetites (aggressive investors can invest larger amounts in mid caps).

Of course, the higher gains in mid caps don't come easy; investors have to brace themselves for higher volatility as well. For various reasons like evolving systems and corporate governance (vis-à-vis the large caps) the mid cap segment is prone to uncertainty. This explains why mid cap stocks/funds usually bear the brunt of stock market volatility. If anyone needed proof of that, the latest market crash provides it in adequate measure.

Year-to-date: Mid caps hit the hardest

(Year to date return indicates the performance of the mutual fund since the beginning of the calendar year upto March 17, 2008. The growth option has been considered for all mutual funds. NAVs as on March 17, 2008.)

As the table highlights, the biggest losers in 2008 have been mid cap funds (as also thematic funds with higher allocations to mid caps). That is not surprising because when markets hit the panic button, generally stocks with the highest risk get dumped first.

And mid caps carry higher risk than large caps. Since systems and corporate governance are still evolving in most mid caps, investors may overlook some of these critical issues during a market rally. However, when markets are volatile, nervous investors consider these issues in a new light and are quick to abandon mid caps if there is any uncertainty.

To that end, large caps given their stable fundamentals (like profitability and sales) and systems are evaluated differently and even when they are abandoned in times of nervousness, at least they are not the first ones to be dumped; that ignominy is reserved for mid caps.

Unfortunately, even investors who have a long-term view on mid caps find it difficult to deal with the extreme volatility. There are doubts about whether mid caps are worth it at all and if markets are in a freefall how long should they remain invested.

To answer these questions, it's important to revisit some points about mid caps:

a) Not all mid caps prove to be worthy investments, even if they are held onto for the long-term. For every HDFC Bank that began as a mid cap to blossom into a large cap, there is a Global Trust Bank that nearly went bust. As a lay investor what are your chances of identifying the right mid cap stock? Not very bright, which is why a professional fund manager is a good bet to identify the best mid caps. Fund managers are more likely to identify the reasons 'not to invest' in mid caps and in this way considerably lower the risk of investing in mid caps.

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b) The other way to reduce the risk, after having identified a 'sound' mid cap investment is to always have a long investment time frame (for mid caps we recommend at least 5 years). As a reputed fund manager observed -- equities are the least risky asset over the long-term and the riskiest assets over the short-term. So if you have taken the mid cap route to generate wealth be prepared for the long haul. This way you will be relatively unaffected by intermittent volatility because you are clear that you expect to remain invested for at least 5 years (which we recommend strongly to our clients).

It is evident from the graph that over the last 5 years (which is when the mid cap rally began picking up steam) mid caps have performed relatively well compared to large caps. Over the last five years, Rs 100 invested in the CNX Mid Cap would have yielded Rs 624 compared to the Rs 473 that the BSE Sensex would have yielded. This gives investors an idea about how mid caps can help their money grow relative to large caps.

However, mid caps have also lost more money for investors over certain time frames; a case in point is the present market decline, which has hit mid caps harder than large caps (refer to the graph for the more pronounced dip in the CNX Mid Cap index over the last few months compared to the BSE Sensex).

Download for free, the guide to investing in mid caps

Lessons for investors

1) Mid caps, as we have seen, can prove very rewarding over the long-term, but that is no green signal to go overboard on mid caps.

2) Invest in mid caps in line with your risk profile. If you have appetite for high risk then you can invest higher in mid caps (your financial planner can recommend a mid cap allocation that is suitable to you).

On the other hand, investors with moderate risk appetite can invest smaller amounts. The present market crash is an easy way to determine your risk appetite. If the sharp decline in mid caps has left you a very worried investor, then your risk appetite is perhaps not as high as you had previously imagined. This is a signal for you to tone down your mid cap investments.

Regardless of your risk appetite and mid cap allocation, you must be prepared to remain invested in mid caps for the long haul. That is the only way you will be relatively indifferent to intermittent volatility in that segment.

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