Investor: “I think we should increase exposure to mid and small cap funds. I am investing for the long term and am not bothered about the short-term volatility. Additionally, I do not foresee any need for this money in at least next 7-10 years. If India does well, we can expect mid and small cap stocks to perform better than large cap stocks. Since our play is anyways on India growth story, we will be better rewarded in smaller stocks”
The argument makes sense too, right? It is difficult to argue with such an argument. And I never had a very convincing response to this question.
However, the timing and the frequency of such questions is very important. All investors chase good performance. Therefore, such questions/feedback become more frequent after mid and small have just had a phenomenal run. During such times, even I have had a dose of optimism, but, as an advisor, I feel a bit worried. What if the outperformance is already behind us? AND whether there will be reversion to mean?
In this post, let’s see if this is indeed the case. Do mid and small cap funds always outperform large cap funds over the long term? And what happens after a sharp outperformance by mid and small stocks?
I had touched a similar topic a few years ago but thought of picking this again, especially given the sharp outperformance by mid and small cap stocks in the past few years.
What to use as proxy for large cap and mid and small cap indices?
For the large cap stocks, we consider Nifty 100. Top 100 stocks.
For the mid and small cap stocks, we consider Nifty MidSmallCap 400 index fund. Stocks 101-500.
This is also the definition of large cap, midcap, and small cap stocks as per SEBI classification.
As per SEBI Classification, top 100 stocks are large cap stocks.
101-250 stocks are midcap stocks
251-500 stocks are small cap stocks.
Now, Nifty MidSmallCap 400 index may seem like a strange choice. We have no index funds or ETFs on this index. It is also not a benchmark that we follow (mentally) to track performance of mid and small stocks. However, by choosing separate indices for mid and small cap stocks, I would have made it a 3-way comparison. Something I didn’t intend to do.
We consider data from April 2005 until December 2024.
Note: For this analysis, I have a year as a 250-day period. Makes my analysis slightly easier.
Let’s first consider the relative performance of mid and small cap stocks against large cap stocks over the long term.
Large Vs. Mid/Small stocks: Rs 100 grows to
Rs 100 invested in Nifty 100 on April 1, 2005 grows to Rs 1,199 on December 24, 2024. CAGR of 13.42% pa.
Nifty MidSmallCap 400 index: Rs 1,990. CAGR of 16.37% p.a.
Clearly, over the past almost 20 years, the mid and small cap index has done far better than large cap index.
Large vs Mid/Small stocks: Rolling Returns
Point-to-point returns can have a start point and end point bias. A good way to compare performance is to compare rolling returns. We compare 3-year, 5-year, 7-year, and 10-year rolling returns basis.
The above chart shows the excess return Nifty MidSmallCap index has given over Nifty 100 in the previous 3-year period. For instance, if the NiftyMidSmallCap index returned 10% (compounded) from April 15, 2015 to April 15, 2018 and Nifty 100 returned 7% over the same period, the excess return is 10%-7% = 3%. For April 15, 2018, we will plot 3%.
Total data points: 4,145
No. of times Mid and Small cap index OUTPERFORMS Nifty 100 = 2,373 (57.2%)
No. of times Mid and Small cap index UNDERPERFORMS Nifty 100 = 1,772 (42.8%)
Average 3-year rolling return (Nifty MidSmallcap 400) = 13.84% p.a.
Average 3-year rolling return (Nifty 100) = 11.43% p.a.
Total data points: 3,645
No. of times Mid and Small cap index OUTPERFORMS Nifty 100 = 2,178 (59.8%)
No. of times Mid and Small cap index UNDERPERFORMS Nifty 100 = 1,467 (40.2%)
Average 5-year rolling return (Nifty MidSmallcap 400) = 13.31% p.a.
Average 5-year rolling return (Nifty 100) = 11.26% p.a.
Total data points: 3,145
No. of times Mid and Small cap index OUTPERFORMS Nifty 100 = 2,448 (77.2%)
No. of times Mid and Small cap index UNDERPERFORMS Nifty 100 = 697 (22.2%)
Average 7-year rolling return (Nifty MidSmallcap 400) = 13.05% p.a.
Average 7-year rolling return (Nifty 100) = 11.06% p.a.
Total data points: 2,395
No. of times Mid and Small cap index OUTPERFORMS Nifty 100 = 2,119 (88.5%)
No. of times Mid and Small cap index UNDERPERFORMS Nifty 100 = 276 (11.5%)
Average 10-year rolling return (Nifty MidSmallcap 400) = 13.87% p.a.
Average 10-year rolling return (Nifty 100) = 11.22% p.a.
Bringing the above analysis together in a table.
We can clearly see that mid and small cap stocks (represented by Nifty MidSmallcap 400) outperform large cap stocks (represented by Nifty 100) across all medium to long-term periods. And the frequency of outperformance increases as the investment horizon increases.
For 3 and 5-year periods, mid and small stocks outperform large cap stocks ~60% of the time. However, for a 10-year period, the frequency increases to almost 90%.
Well, this data makes the case for investing more in mid and small cap stocks strong.
However, even with these strong odds, what if you enter the mid and small cap funds at a wrong time?
What happens when Nifty MidSmallCap 400 index beats Nifty 100 by 5%?
Let’s see how Nifty MidSmallCap 400 index has fared (compared to Nifty 100) when the outperformance in the previous 5 years was more than 5% p.a.
There were 629 such observations.
What happened over the next 3 and 5 years?
Over the next 3 years, Nifty 100 has tended to outperform Nifty MidSmallCap 400 index.
However, over the next 5 years, we go back to normal. Nifty MidSmallCap 400 tends to beat Nifty 100 2/3rd of the time.
Fair enough. Where do we stand now?
As on December 24, 2024, Nifty MidSmallCap 400 has outperformed Nifty 100 by a massive 13.39% p.a. over the past 5 years. We have never seen such an outperformance before. This is also evident from the 5-year rolling returns chart.
In fact, over a 5-year period, the outperformance had never breached 10% before May 2024. So, we have no past data for 3 and 5-year periods when the outperformance is more than 10% in the previous 5-year period.
Will there be any mean reversion? I don’t know the answer but there is clear need for caution. I trust your judgement on this.
Points to Note
- Past performance (or outperformance) does not guarantee future performance (outperformance).
- Many investors invest in mid and small cap funds for a wild outperformance over large cap stocks/funds. However, the large-cap index (across all rolling returns period) has delivered ~11%. On the other hand, the mid and small cap index has delivered ~13%. Hence, the outperformance is about 2% p.a. Not saying 2% is less, especially when you compound over the long term. However, you must set your expectations accordingly. If you go into mid and small caps planning to obliterate large cap funds by 8 to 10% over the long term, you are preparing yourself for a disappointment. At least the past data suggests so.
- With my limited experience, for most investors, long-term is just a series of short-term investments. It is easy to look at the past returns and make strong statements. However, with investments, it is not just the destination, but the journey also matters. Many investors (who may call themselves long-term investors) worry at the slightest hint of underperformance (even short-term).
I do not intend to suggest that this is a good time to invest in large cap funds OR a bad time to invest in mid and small cap funds. OR that this is a good or a bad time to invest in domestic stocks in general. This post is just about sub-allocation within your equity portfolio. How much to allocate to large cap funds and mid and small cap funds in your portfolio?
I suggest that you do not make this a binary decision. You can allocate to both large and mid/small cap stocks and make tweaks to allocation percentages basis your outlook. If you want to keep things simple, you can simply invest in a single fund that gives you exposure to both types of stocks. Within the passive space, a simple Nifty 500 index fund is a good example.
Note that, a far more important decision from the portfolio perspective is the top-level asset allocation. How much to allocate to equity, debt, and gold in the portfolio? Personally, I follow a rule based approach to portfolio construction that makes my life easy.
Source/Additional Read
Featured Image: Unsplash
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This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.
