In investing, Nothing works all the time

There is always a flavour of the season in investments. Sometimes, it is large cap stocks. Sometimes, it is small cap stocks. It can be gold. Or Banking or Pharma stocks. Bitcoins. Or international mutual funds (in 2020).

Recent outperformance always attracts attention and investor money. To figure out, you just need to look at how quickly the size of the best performing mutual fund grows.

However, when it comes to investing, nothing works all the time.

And this applies not just to asset classes or stock categories, it applies to investment strategies too. We have seen this in all the strategies we have tested.

Today’s outperformer can be tomorrow’s laggard. Or vice-versa.

An investor must never forget this. Diversification is of paramount importance.

In this post, I will not focus on asset allocation, but sub-allocation within the equity portfolio.

I regularly come across portfolios that are very heavy on mid and small cap mutual funds. The investor rationale is that the small and midcap stocks offer higher return potential over the long term. The real reason, I suppose, is usually recent outperformance.

The higher returns (for smaller stocks) looks very intuitive. After all, the smaller stocks have greater scope to grow. However, what does the data tell us? Does the higher returns theory for smaller stocks hold?

Let’s find out.

Performance Comparison

We compare the performance of the following 4 indices/funds since April 1, 2015.

1. Nifty 100 (represents Top 100 companies based on full market cap)
2. Nifty Midcap 150 (represents 150 companies ranked 101-250 based on full market cap)
3. Nifty SmallCap 250 (represents 150 companies ranked 251-500 based on full market cap)
4. HDFC Liquid Fund (a liquid fund)

SEBI defines the various types of companies as follows.

Large Cap Company: 1st-100th company in terms of full market capitalization

Mid Cap Company: 101st-250th company in terms of full market capitalization

Small Cap Company: 251st company onwards in terms of full market capitalization

Nifty 100 represents the large cap stocks as per SEBI definition. Nifty Midcap 150 represents the mid cap stocks and Nifty Smallcap 250 represents small cap stocks.

We compare the performance of indices since April 1, 2005.

Rs 100 invested in the above investments grows to

Nifty 100: Rs 689. CAGR of 13.33% p.a.

Nifty Midcap 150: Rs 791. CAGR of 14.34% p.a.

Nifty Small Cap 250: Rs 598. CAGR of 12.29% p.a.

HDFC Liquid: Rs. 300. CAGR of 7.38% p.a.

Among the equity indices, the smallcap index has delivered the lowest returns over the last 15 years. This will come as a surprise to many investors.

Now, to the calendar year returns.

We have the return performance for 16 calendar years, including 2 incomplete years.

Among the equity indices (leaving out HDFC Liquid),

Nifty 100 has been the top performer in 6 years and the worst performer in 8 years.

Nifty Midcap 150 has been the top performer in 6 years and the worst performer in just 1 year.

Nifty Smallcap 150 has been the top performer in 6 years and the worst performer in 7 years.

If we include HDFC Liquid fund in the mix, the liquid fund has been the best performer in 6 out of 16 years. Therefore, something as simple as a liquid fund (or a bank FD) has beaten stocks almost 40% of the time.

As investors, we must keep this in mind.

Coming back to large, mid and smallcap stocks, the data considered does not support the higher returns theory, especially for the small cap stocks/funds. Even over a 15-year period, the smallcap index has delivered lower returns than the large cap index (Nifty 100).

Not just that, the following rolling returns chart suggests that the Smallcap index has delivered lower returns with much higher volatility.

What should you do?

We can see that the baton of the best performing equity fund category keeps passing.

And we can see that the small cap stocks implode on a regular basis. Hence, it is important that you do not limit your equity portfolio to just small cap stocks or funds.

Do not let the recent performance of any category blur your judgement.

Have a good mix of large, mid, and small cap funds. I do not want to go into the exact allocation between large, midcap, and small cap funds. You can decide based on your market outlook and risk appetite.

In my opinion, a large-cap heavy portfolio or even a portfolio with only large cap funds/stocks is quite fine.

Note that I am just talking about the domestic equity portfolio. Asset allocation comes before that and must form the bedrock of your portfolio. Asset allocation among various asset classes is much more important than the allocation between large, mid, and small cap stocks in your equity portfolio.

Points to Note

1. This topic (“Nothing works all the time”) would have been better addressed with the usage of multiple asset classes and demonstrating the benefits of asset allocation and diversification. We have used only equity and debt in this post. A better choice would have been to add gold and international equity to this exercise. We have done this exercise earlier. Hence, thought of looking at this exercise from the market cap spectrum angle.
2. I have considered the indices for comparison. While we have had index funds in the large cap space for some time, the indexing options in the midcap and small cap space are rather limited. Currently, only one AMC offers index funds in mid and small cap space. Even these options are quite new (launched in September 2019).
3. If you are investing in mid and small cap funds, you have probably taken exposure to actively managed funds. We can see from the below figure that active funds have done quite well compared to smallcap index. However, the outperformance seems to have come down in the recent years (a rolling returns analysis would have been better). I can’t comment about the source of outperformance (stock-picking or investing outside the index) and don’t know if the outperformance will continue in the future. For deeper active vs passive performance, refer to the SPIVA India Scorecard Year End-2019 report.
4. If you pick up a small cap stock, you can hold it for a long time as it keeps growing. You won’t be forced to sell. However, with market cap-based indices, as the stock becomes bigger, it moves out to the midcap index and onwards to the large cap index. That is a drawback with small cap index. Good companies will eventually move out of the index. While a small cap fund may not be forced to sell such stocks, it must have at least 65% of its portfolio in such small cap stocks (as per SEBI classification). This minimum threshold was introduced in October 2017.

Test Results of other Investment Strategies

Over the past few months, we have tested various investment strategies or ideas and compared the performance against the Buy-and-Hold Nifty 50 portfolio. In some of the previous posts, we have:

1. Assessed whether adding an International Equity Fund and Gold to an Equity portfolio has improved returns and reduced volatility.
2. Does Momentum Investing work in India?
3. Does Low Volatility investing beat Nifty and Sensex?
4. Considered the data for the past 20 years to see if the Price-Earnings (PE) multiple tells us anything about the prospective returns. It does, or at least has in the past.
5. Tested a momentum strategy to shift between Nifty 50 and a liquid fund and compared the performance against a simple 50:50 annual rebalanced portfolio of Nifty index fund and liquid fund.
6. Used a Simple Moving Average Based Market Entry and Exit Strategy and compared the performance against Buy-and-Hold Nifty 50 over the last two decades.
7. Compared the performance of Nifty Next 50 against Nifty 50 over the last two decades.
8. Compared the performance of Nifty 50 Equal Weight vs Nifty 50 vs Nifty 50 over the last 20 years.
9. Compared the performance of 2 popular balanced funds against a simple combination of an index fund and a liquid fund.
10. Compared the performance of a popular dynamic asset allocation fund (Balanced advantage fund) against an equity index fund and see if it has been able to provide reasonable returns at low volatility.

Additional Links/Source

NiftyIndices

ValueResearchOnline