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Many AMCs such as Aditya Birla Sun Life MF, ICICI Prudential MF, Motilal Oswal MF, and Nippon India MF have launched a few small cap and mid-cap focused passive funds in recent years. As of the end of 2021, mid-cap and small cap index funds and ETFs managed Rs. 2,000 crore worth of net assets.
Is adopting the passive fund route to midcap and small cap investing, rewarding for investors? A Business Line Portfolio analysis shows that it is especially so for mid-cap stocks. A rolling returns analysis for actively managed funds over the last 7 years using ACE MF shows that while several small cap funds have outperformed the Nifty Smallcap 250 TRI (total return index), almost all mid-cap funds have failed to beat the Nifty Midcap 150 TRI during this period. We have looked at 1, 3, and 5-year period daily rolled returns between Jan 2015 till date for funds with at least five years’ history.
The Nifty Smallcap 250 and the Nifty Midcap 150 indices provide a good representation of the universe of stocks that these funds must invest in (at least 65 per cent of their portfolio), and so have been used for gauging fund performance. They also figure among the AMFI list of 1st tier benchmarks that AMCs must use from December 2021 as directed by SEBI.
Middling midcap returns
Over the last 7 years, almost all active midcap funds have lagged the Nifty Midcap 150 TRI on 3-year and 5-year rolling returns (CAGR). The one exception was Axis Midcap Fund which outperformed the index – it’s average 5-year return of 15 per cent exceeded the index’s 13.3 per cent. Two others, Kotak Emerging Equity Fund and DSP Midcap Fund just about matched the index’s 5-year return. None of the funds came close to matching the index’s average 3-year return of 17 per cent over this period.
On average, the midcap funds fell short of the index’s 3-year and 5-year returns by 2.7 to 11 percentage points and 0.5 to 5.4 percentage points, respectively.
What’s more revealing is that except for Axis Midcap Fund -which like the index had no instances of negative 3-year returns over the last 7 years -all other funds delivered negative returns some time or the other. This happened as infrequently as 2 per cent of the time for Quant Midcap Fund to as much as 24 per cent of the time for Aditya Birla Sun Life Midcap Fund.
Kaustubh Belapurkar, Director – Manager Research, Morningstar India says, “Unlike small cap funds which have a larger pool to pick from, midcap funds must invest 65 per cent of their corpus in 150 stocks. Polarization in returns - where only a few stocks in the index do very well - is a reason for active fund underperformance as funds may not always hold these stocks or may not have meaningful exposure to them.” Vidya Bala, Co-founder, PrimeInvestor.in, also adds that liquidity issues in some of the stocks which results in impact cost when buying / selling them makes it difficult for actively managed funds to beat the index.
For the same reason, if you decide to go for passive mid-cap funds, keep the tracking error in mind. Most Nifty Midcap 150 index funds / ETFs have been launched only in the last one or two years and one needs to wait to see how closely they track the index.
The select small caps
In contrast, data shows that 70 per cent of the actively managed small cap funds have, on an average, delivered higher 3-year and 5-year returns than the Nifty Smallcap 250 TRI during the period under consideration. On average, the outperforming funds exceeded the index’s 3-year and 5-year returns (CAGR) by 0.8 to 9.3 percentage points and 1.2 to 8.6 percentage points, respectively. These funds also had fewer instance of negative returns than the index.
Compared to the small cap index’s 250 stocks, most active small cap funds typically hold a portfolio of 40 to 80 stocks. Given the extremely wide-ranging performance of these stocks, picking the better ones instead of holding all the 250 (or even beyond) with minuscule weights can offer superior returns. For example, while the Nifty Smallcap 250 Index returned 242 per cent since March 2020 lows, individual stocks in the index returned anywhere between minus 53 and 11,133 per cent between March 2020 till date.
Small cap funds from SBI MF, Axis MF, and Nippon India MF have been the top performers. They have delivered an average 3-year return of 12.5 to 14.8 per cent versus the Nifty Smallcap TRI’s 5.5 per cent (CAGR) over the last 7 years.
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