Small And Mid-Cap Funds Are More Volatile Than Large-Cap Ones

I have invested in Franklin Bluechip, Birla Frontline Equity, HSBC Mid-Cap Equity and HDFC Top 200. I have lost some of my original investment in HSBC Mid-Cap Equity. Should I wait for this fund to do better or choose another one? Please evaluate my portfolio and suggest how I could earn higher returns. I am using these funds to add to my retirement savings. I plan to retire in 2025.

- Parag Shastri

The majority of your current portfolio is invested in Large-Cap funds (Birla Sun Life Frontline Equity, Franklin India Bluechip and HDFC Top 200). These are some of the best performing funds in their category and have consistently generated high risk-adjusted returns. These funds have outperformed the Sensex as shown in Table 1.

However, as you pointed out, HSBC Mid-Cap Equity Fund has not added value to your portfolio. This small and Mid-Cap fund has underperformed its benchmark (the S&P BSE Mid-Cap) and its category. You should redeem your holdings in this fund and enhance your returns by investing in other small and Mid-Cap funds as your investment horizon is quite long. Small and Mid-Cap funds are subject to short-term volatility but have the potential to outperform Large-Cap funds over the long-run.

Small and Mid-Cap funds generally invest in companies in the early stages of their business cycles. Hence, small and Mid-Cap companies may have higher growth rates than Large-Cap companies which are already mature. Over time, small and Mid-Cap companies may eventually graduate to Large-Caps and benefit from ‘re-rating’ – this will generate higher returns for investors in such funds.

Small and Mid-Cap companies tend to outperform Large-Caps in the upswings of the economic cycle. This phenomenon may occur when India’s economy recovers. The worst economic slowdown in 10 years may have bottomed out as growth is expected to rise to 5.7 per cent in FY14 (India’s GDP growth is expected to fall to five per cent in FY13 from 6.2 per cent in FY12)*. The RBI may now have more room to reduce interest rates to stimulate growth as headline inflation is now within the central bank’s comfort zone. Additionally, the recent correction in commodity prices may push down the current account deficit (CAD) which rose to a record high of 6.7 per cent in the third quarter of FY13 – this may also induce the apex bank to pursue growth-oriented monetary policy.

The graph shows that the S&P BSE Mid-Cap index has generally outperformed the Sensex in the rising markets.

The funds shown in Table 2 have outperformed HSBC Mid-Cap Equity and have also generated higher returns than the S&P BSE Mid-Cap. However, high returns come at a price - small and Mid-Cap funds are more volatile than Large-Cap funds. You should limit your exposure to small and Mid-Cap funds and have the bulk of your portfolio invested in relatively-safer Large-Cap funds. Alternatively, you could opt for Multi-Cap funds – these funds invest in a mix of Large-Cap and small and Mid-Cap stocks and offer slightly higher returns than Large-Caps.

Your asset allocation and small and Mid-Cap exposure should ideally be governed by your risk tolerance. A financial advisor can help you determine this. As you approach retirement, you should gradually reduce your small and Mid-Cap exposure and your equity investments so that the majority of your overall portfolio is invested in debt to minimise the risk of loss. 

In conclusion, you should exit HSBC Mid-Cap Equity and have the bulk of your portfolio invested in Large-Cap funds. You could allocate a small portion of your portfolio to small and Mid-Cap funds to increase the rate of return on your investment over the next 12 years. 

*RBI projections