Mid Cap Funds: For the 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.

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.

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).

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).

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.

3) 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.

Don’t time the market

It is more important to spend time in there

The law of demand tells us that higher prices bring down demand and vice versa. But, there are exceptions to this rule, the biggest being the stock market — as prices go up, more investors flock to the stock market, and when the markets fall and stocks become cheap, more investors want to leave the stock market.

Counterproductive as it is, most investors thus end up buying when prices are high and selling when prices are low.

Do not follow the herd
Investors typically follow what everybody around them happens to be doing - buy if everyone is buying, sell if they are selling. But, this does not help because investors are essentially trying to enter or leave the stock market based on their perception of where it is headed. In short, they are trying to time the market, something even professional investors would agree is very difficult.

Invest regularly
A number of experts have been shouting from the rooftops since the Sensex touched 6,000 that the market is overvalued. But, that didn’t stop the index from rising 250% to cross the 21,000 level or falling by around 30% from that level. And now, when the markets are around 16,000, the experts seem to be suggesting that it’s the right time to buy, as stocks are available at lesser prices.

How does an individual protect his or her investments from volatility in the stock market? The answer lies in the age-old adage, “invest regularly.” How does regular investing help? The simplest answer seems to be that an investor can keep investing even if he does not have a large amount of money to invest. Also, with regular investment, money earmarked for investment does not go towards spending.

Regular investing also brings “cost averaging” into play. Say an individual invests Rs5,000 to buy 100 shares of A Ltd at the rate of Rs50 per share. Some time later, say the price drops to Rs25. Now if he decides to invest Rs5,000 again in A Ltd, he ends up buying 200 more shares. Now he has 300 shares of A Ltd. Thus, his average price per share now is Rs33.33. Hence, he can make a profit once the share price goes beyond Rs33.33 and doesn’t have to wait till it reaches Rs50 again.

Mr. Market and YOU

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.' This was how Benjamin Graham defined 'investment'. And rightly so! At these times, when the markets are witnessing high levels of volatility, it becomes an ardent need for stockbuyers to understand this difference between a speculative activity and investment. It requires just a misguided step for investor to turn his investment venture into a speculative misadventure.

In this regard, Graham's parable of 'Mr. Market' stands in good stead. This is, probably, one of the best metaphors ever created for explaining how stocks can become mispriced. Through this parable, Graham asks investors to imagine a non-existing person called Mr. Market who is your (investor's) partner in a private business. He appears daily and names a price (stock quotation) at which he would either buy your interest or sell you his. Now, despite the fact that both Mr. Market and you have stable business interests, his quotations are rarely so. At times, he falls so ecstatic that he sees only the favourable factors affecting business. And this is the time he would name a very high buy-sell price because he fears that if he does not quote such a high price, you would buy his interest in the enterprise and rob him of imminent gains.

And then there are times when this very Mr. Market is so depressed that he sees nothing but trouble ahead for both business and the world. These are the occasions when he would name a very low price, as he is terrified that if he does not do so, you would burden him (sell him) with your interest in the business.

Now, Graham says that if you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily communication determine your view of the value of your interest in the enterprise. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But at the rest of the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

What Graham tells investors through this parable of Mr. Market is that they should look at market fluctuations in terms of the Mr. Market example. They should make these fluctuations as their friend rather then their enemy. This means that they should neither give in to temptations that rising markets bring with them nor should they think of doom when the markets are falling incessantly.

Coming back to the abovementioned definition of an investment operation, investors need to have a long-term (two to three years) perspective when making their investment decision. Only then would the promised safety of principal and an adequate return accrue to them. Now, the term 'adequate return' typically varies from investor to investor. A high-risk investor would demand a high return from his investment from the extra bit of risk he is taking. On the other hand, a low-risk investor would settle for a relatively lower return. Having said that, in a rising market, expectations tend to be on the higher side without a fundamental premise. Here is where 'Mr. Market' could mislead you. If you believe that 15% per annum is an 'adequate return', then stick to that irrespective of whether it is a bull market or a bear market. Otherwise, you are changing i.e. risk profile is changing, which is not required.

As Graham says, '...in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.' Happy investing!

With index funds, choppiness won’t hurt

The passively managed funds are particularly good for building a milestone corpus Equity markets have undergone quite a bit of consolidation in the last few weeks. For a retail investor,stock-picking now seems much riskier than earlier.

That said, the low levels of current markets make many an investor wonder if they can enter at these levels. With a limited expertise in stock selection, it is a tough task to get the value buys right. Also, getting stuck to poor performers can be pretty disheartening when the bulls take charge of the market again.

Equity mutual funds, on the other hand, become somewhat unpredictable in their behavior in such turbulent times. Even if the investor wants to enter the markets at a certain level, the fund that he invests in might choose instead to stay put in cash. When taking a call on the overall market, therefore, index funds turn out to be a better choice for investments.

Index funds are passively managed funds and replicate the movement of an index like the BSE Sensex or NSE Nifty or any sector specific index without attempting to beat it. These will give the upside from the expected bull run in the exact proportion of the market movement and will not lag or lead the index. There is a common misconception that funds with a passive management style provide lesser returns as compared to actively managed equity funds. However, a large proportion of diversified equity funds underperform the index over long time horizons.

The following table shows the performance of equity mutual funds vis-à-vis the market indices.

Index returns (%) 1 yr 2 yrs 3 yrs

BSE Sensex 21.86 21.63 35.95

S&P CNX 26.08 21.88 34.18

NiftyCrisil Equity 17.46 12.49 28.65

Unfortunately, very rarely will you find any distributor recommending index funds, thanks to the low commissions they offer — another reason few people are aware that index funds so much as exist.

Most index funds have neither entry load nor exit load (beyond a minimum holding period), which ensures that the entire invested money is deployed in the equity markets. To add to this, the expense ratios are much lower for index funds ~1-1.5% and keep going down further as their AUMs increase. The composition of the target index is a known quantity; so the running costs are less for an index fund as no stock pickers or equity analysts are required.

One obvious disadvantage of index funds, however, is that they cannot outperform the broad markets unlike actively managed funds. However, for long-term investors who want to avail consistent gains and take advantage of the growth story in India without constantly churning their mutual funds portfolio, there is nothing better than an index fund. When it comes to building a corpus for milestones such as retirement, index funds are clearly a superior choice.

Index funds are offered by a majority of mutual fund houses like ICICI Prudential, Birla Sun Life, Franklin Templeton, HDFC, UTI, etc. All these are mutual funds and can be bought through mutual fund distributors. The Nifty BeES by Benchmark, though, is an exchange traded fund (ETF) listed on the NSE. To buy an ETF, an investor need to have a demat account and an equity broking account.

Unlike actively managed equity mutual funds, Index funds offered by different mutual fund houses do not vary in their returns significantly (see table: Index picks). Hence, the parameters to choose an index fund are different from those used for an actively managed fund. Expense ratio and tracking error are the most important factors while choosing an index fund. Expense ratio indicates the cost of investing in the fund and the tracking error indicates how much the returns of the index fund differs from its underlying index. Low tracking error and low expense ratio are desirable. Typically, higher AUM results in lower expense ratio. It also keeps an index fund stable and not prone to large withdrawals by major investors.