As an investor, you always had the choice between the relative stability and long-term growth of large-cap funds, and the potentially higher returns accompanied by higher volatility of small-cap funds. Let’s take an objective view of this comparison. This comparison has become more topical now, after fund categorisation norms of the Securities and Exchange Board of India (Sebi). After implementation of the new norms, a large-cap fund can buy only large-cap stocks, defined as the top 100 by market capitalisation. Earlier, as long as the scheme information document (SID) permitted, the fund could buy mid- or small-cap stocks as well. Similarly, small-cap funds will buy only small-cap stocks, defined as 251st and below as per market capitalisation. 

To get a perspective on higher returns and higher volatility of small caps over large caps, we have taken the BSE 100 index as the proxy for large caps and BSE Small Cap index as the proxy for small caps. Fund portfolios will be different, so to compute returns, we have taken one-year rolling returns, on a daily basis, over a 10-year period. From 31 March 2008 to 31 March 2009 as the first one-year return data point, returns from 1 April 2008 to 1 April 2009 as the second one-year return data point, and so on, till 31 March 2018. 

Over this 10-year period, taking the average of 2,232 data points, the return from BSE 100 is 14.4% and 20.6% for the small-cap index. Since we have an adequate number of data points over a reasonably long period of 10 years, it is established that small caps gave higher returns. The highest return from large caps, on a one-year rolling basis over this 10-year period, is 118.3%, and from small caps 197.5%. Here also we see the outperformance.

But what about volatility? The minimum return from large caps, on a one-year rolling basis, is -39.9%, while for small caps it is -58.6%.

This means that small caps can give you higher highs and lower lows, which is volatility in simple language.

Let's look at one more data point here: median return. The median return from large caps is 11.2%, higher than 7.6% of small caps. This is interesting, because the average return from small caps is higher. This shows that small caps have a higher incidence of lower or negative returns. The average return of small caps is higher by virtue of higher highs.  

Fund performance

To look at fund performance, we have taken indices by the Association of Mutual Funds of India (Amfi) for large- and small-cap funds (you can see them on www.amfiindia.com). The large-cap funds index comprises 30 funds and the small- and mid-cap funds basket comprises 32 funds. Over a 10-year period till 31 March 2018, large-cap funds have given a compounded annual growth rate (CAGR) of 10.6%, but small- and mid-cap funds have outperformed with 14.7% CAGR. This outperformance of small- and mid-cap funds holds true over shorter periods as well. Over five years till 31 March 2018, these funds have delivered 23.7% CAGR against 14.9% of large-cap funds. Over the past three years, it is 12.4% over 7.6%.  

This is performance per se. To compare this with the BSE index performance, over 10 years till 31 March 2018, BSE 100 index gave a return of 8.2% CAGR. Which means large-cap funds (10.6% CAGR) have outperformed. The BSE small-cap index has delivered 8% CAGR, and the mid-cap index has delivered 9.5% CAGR, hence small- and mid-cap funds’ 14.7% is a good outperformance. 

 There are, however, imperfections in the comparison above. One, fund portfolios are different and so far, there was no strict definition of large- and small-cap funds. Two, small- and mid-cap fund performance includes mid, small and maybe a bit of large caps as well. Three, BSE indices are index returns only, without dividends. 

Takeaways 

When we look at the BSE Small Cap index performance over BSE 100 index, small-caps have given higher highs and lower lows, i.e. higher returns with higher volatility. However, when we look at fund performance through Amfi indices, the small- and mid-cap fund index has outperformed the large-cap fund index over all time horizons (1-year, 5-year, 10-year, and others). In the small- and mid-cap space, fund managers have a wide choice of stocks to pick and play with, including under-researched or under-discovered stocks, to outperform. 

Small- and mid-cap funds have delivered superior returns, but as long as you have a long enough horizon and some appetite for volatility, you can allocate to large-, mid- and small-cap funds, as per your risk appetite and horizon. The basic tenet of investing—allocation—remains unchanged. You should not allocate to only one segment, even if you have the horizon.  

Joydeep Sen is founder, wiseinvestor.in

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