When investing in mutual funds, we often hear about large-cap, mid-cap, and small-cap mutual funds. For a first time investor, these can be overwhelming terms and make the decision to invest complicated. Many questions come to the mind:
How are these different from each other?
Where should I invest?
What are the risks and returns?
Which are the best funds to invest?
Through this post, we will unravel the key differences between mid-cap and small-cap funds and answer all these questions, which will aid the investing thought process.
What are Mid Cap Funds?
As the name suggests, mid-cap funds invest in mid-cap stocks listed on the stock exchange. As per SEBI’s classification, a mid-cap stock is defined as the 101st largest stock to the 250th largest stock basis the market capitalization. Market capitalization is Free Float of a stock * Current Price. Thus, mid-cap mutual funds can buy stocks between the 101st to 250th. These companies are smaller than large-cap companies, which are the top 100 companies in India. Some people misconstrue that mid-cap companies are not as good as large-cap companies since these are smaller.
It is important to see things from the right perspective. Most of these companies are smaller than large-caps since they are at an early stage of evolution. Also, some of them operate in sectors which itself are small. For e.g. Educomp Solutions (a mid-cap stock) is the leader in India in the digital education space but digital education in India itself is at a nascent stage and just picking up.
What are Small Cap Funds?
Small-cap funds invest in small-cap stocks listed on the stock exchange. Like mid-cap, there is a SEBI classification for small-cap as well. All stocks from the 251st stock onwards are classified as small-caps. Currently, there are about 7800 companies which are listed on the stock exchange, so all stocks from 251st to 7800th are small-cap stocks. As we can see the universe of small-cap stocks is much bigger than mid-cap stocks which gives the fund manager a wide array of options to choose and invest. However, there are many small companies that are not considered investable or weeded out by mutual funds in their filtering and due diligence process. Small-cap funds aim to invest in companies that are a quality franchise, present healthy growth opportunities, good financials, and good management.
Key Differences Between Mid Cap & Small Cap Mutual Funds
As mentioned earlier, mid-cap funds invest in larger companies as compared to small-cap funds, so the size of the mid-cap portfolio is larger than the small-cap portfolio.
The returns from both mid and small-cap funds are higher than large-cap funds over a long period. This is because mid and small-cap companies are at an early stage of growth and can grow much faster over a long period. Some of the large-cap companies today like Infosys and HDFC Bank were small & mid-caps in the 90s. But as they grew to become today’s large-cap, returns have been manifold. Among the two, small-cap funds have a higher return potential.
Small-cap funds are riskier than mid-cap funds, this is because small stocks are at an initial stage of growth and might not have a large enough balance sheet to face contingencies. Also, small-cap companies are less researched and management credentials could be unknown to the market. So small-cap stocks could fall more than mid-cap stocks during a market downturn.
This refers to sharp movements in stock prices or fund NAVs. Small-cap funds are more volatile than mid-cap funds. There could be times when they could witness sharp moves – both on the upside and downside.
Small-cap funds are more suitable for people who have a high-risk appetite and a long investment horizon. One should keep at least 10 years in mind when investing in small-cap funds. Mid-cap funds also carry risk but people with 5-10 years of time horizon can look to invest in these funds.
Both mid and small-cap funds present a strong case for investment. Our economy is still in a developing stage and has miles to go before we become a large economy befitting our country’s size, population and resources. In this journey, many mid and small-cap companies of today which exhibit strong growth will become tomorrow’s large caps and thereby create enormous wealth for investors. However, one needs to be mindful of high volatility and risk when investing in these. It is important to follow your asset allocation, not over-allocate and invest blindly just looking at returns. We recommend you invest in these keeping all the above factors in mind. If you have decided to invest in equity mutual funds but are afraid of severe volatility and risk, it is better to stick to large & multi-cap funds.