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New investors should not put all their money in mid-cap funds

If you had invested Rs 1 lakh in Tata Equity PE fund — the best-performing mid-cap fund — one year ago, your money would have grown to Rs 1.46 lakh now. And if you or your financial planner weren’t smart enough to select the potential best performer and had put the same amount in an average-performing fund, your returns still would have been a good 30 per cent plus.

The rally in the mid-cap index, for some time, has been quite exemplary. On February 6, the Nifty Mid-cap 100 index closed at a record high of 16,174, surpassing its previous peak of 16,076 on October 5, 2016.

There are always fears when the overall market or a particular segment is doing exceptionally well. Consequently, investment advisors are turning cautious and advising investors not to go overboard with their allocation to these funds based on past performance.

Mid-cap funds have turned more expensive than large-cap funds. At the end of January 2017, the average price-to-earnings (PE) ratio of mid-cap funds stood at 30.13 while that of large-cap funds was 26.78. Nilesh Shah, managing director, Kotak Mahindra Asset Management Company, offers two reasons for this. "Select mid-cap stocks across sectors like auto components, building materials, consumer durables, electrical materials, textiles, etc, are likely to gain market share from unorganised sector firms due to demonetisation and the goods and services tax (GST) roll-out.

The market expects this gain in market share to translate into faster earnings growth. Mid-cap valuations are also at a premium due to fund flows. Retail investors who have entered equities via the SIP route in large numbers over the past few years have opted for mid-cap funds, unlike FIIs who stick to large-caps. Investment advisors are warning their clients to be cautious on account of valuations. When one category already trades at a premium to another, the probability of large and continuing outperformance declines.

Says Kunal Bajaj, founder and chief executive officer, Clearfunds.com, a Sebi-registered online investment advisor: "Given the current higher valuations of mid-caps, it is difficult envisage a scenario where the returns will be in mid- and small-caps but not in large-caps."       

Another reason for having only a limited exposure to mid-cap funds is that they tend to fall more in declining markets. Says Bajaj: "In times of market and economic weakness, mid-cap stocks underperform large-caps significantly. In 2008, 2011 and 2013, the Nifty Midcap 100 Index underperformed the Nifty by 7.6 per cent, 6.38 per cent, and 11.86 per cent respectively.”

The assets under management of mid-cap funds have also risen significantly from around Rs 15,365 crore at the start of 2014 to Rs 49,600 crore at the start of 2017.

In long-term investment portfolios, financial planners allocate 65-75 per cent to large-cap funds and 25-35 per cent to mid- and small-cap funds. If existing investors' allocation to the latter category has grown above the pre-decided level, rebalance and bring it to the pre-decided level. When selling, minimise costs such as exit load and capital gains tax.