Denali in Alaska (North America’s tallest mountain) had 1,100 climbers in 2018, Mont Blanc in Europe had 25,000 and Kilimanjaro (Africa’s tallest mountain) had 50,000 climbers. In contrast, the Nepal government issues about 300-400 climbing permits each year to summit Mount Everest. The reason is obvious: the Everest, at 8848 metres, is the tallest and riskiest to climb. In comparison, the others are relatively less risky to ascend.

The investment world is no different with more people attracted towards low-risk investments like products that give assured returns, while relatively higher risk keeps people away from market-linked products like mutual funds. However, declining returns from traditional-assured-return products and rising lifestyle inflation as well as the Mutual Funds Sahi Hai campaign by the Association of Mutual Funds in India has led to increased interest in mutual funds. But it is ironic that mutual funds have more takers for riskier equity products than for debt products which carry a relatively lower risk.

Let’s delve a bit deeper into the risk-return aspect of equity funds starting with large-cap equity funds. These funds, as the name indicates, have a portfolio of large market capitalization stocks which are typically well-researched and closely tracked. Further, news about them is well amplified, allowing analysts to take informed investment decisions. Being well-established diversified companies, they are more resilient to economic cycles. Large-caps are also highly liquid and widely held, owing to which they are less volatile. However, a relatively lower risk also means their returns can be commensurately lower.

The next sub-category within equity funds is mid-cap funds whose portfolio includes relatively smaller companies which are not as widely held or researched. They are relatively less liquid, owing to which price fluctuations are higher. While their smaller size adds nimbleness and may make them more responsive to opportunities, it also makes them more susceptible to business cycles. Thus, mid-cap funds may be relatively riskier, but their return potential is certainly higher.

Let’s look at some numbers to elaborate the above aspects. Over the last 10 years, the mid-cap funds category has outperformed large-cap funds by 3.5% on an annualized basis. This outperformance is also reflected in the SIP (systematic investment plan) performance over the last 10 years where the differential was 2.5% on an annualized basis (all returns are as of end August 2019; past performance may or may not be sustained in future).

Further, while mid-cap funds saw a 28% and 12% upside vis-à-vis large-cap funds during 2014 and 2017, respectively, they also fell more during the 2018 carnage, when the returns differential was a negative 10%.

How does one, therefore, manage the key challenge of volatility in mid-cap funds? A prudent option is to invest systematically across longer time frames. If we consider the rolling performance of the Nifty Midcap 150 TRI index since its inception (2005) bucketed across all three-, five-, seven- and 10-year periods, we observe instances of negative returns during three- and five-year periods, but none over seven- and 10-year periods. Thus, history tells us that longer investment periods help ride out volatility. It is also observed that negative returns are higher over shorter time frames and taper off as the holding period increases.

The second is liquidity risk. Mid-caps, typically, have lower liquidity vis-à-vis large-caps and this could impact the portfolio during periods of higher redemption. The same can be mitigated by investing in adequately diversified funds.

The third is the risk of timing the market. Investors typically like to invest in good times and prefer to stay away in bad times. However, not staying invested across market cycles derails wealth creation. The right way is to stay consistently invested and reap the rewards. The full period returns from 2005 to 2019 by staying invested in the Nifty Midcap 150 TRI index are 14% annualized. They drop to 9% if one misses the 10 best days, and further drop to 6% if one misses the best 20 days. In timing the market, one may not just miss the bad days but also some of the good days. Hence, staying invested across time frames is the key to wealth creation.

A practical strategy often used to manage this behavioural challenge is to have a core and satellite portfolio. The core includes large-cap funds which offer close-to-market returns and the satellite includes mid-cap funds which have the potential for higher returns, giving investors the best of both worlds. One could choose the quantum of satellite funds on the basis of their risk appetite. However, investors must ensure that their investment horizons are above five years and investments are regular via the SIP route.

It is famously said, “If you are not willing to risk the unusual, you will have to settle for the ordinary." Investing in mid-cap funds can help you rise above the ordinary in the wealth creation journey.

Sanjay Sapre is president, Franklin Templeton Investments

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