Where to invest: Small cap, mid cap, large cap, or multi-cap funds?

One of the first questions investors ask when they start investing is whether should they invest in large-cap funds, mid-cap funds or small-cap funds, or a mix of all, which are multi-cap and Flexi-cap funds.

Large caps by nature are the least volatile and small caps are the most volatile. Naturally one would expect most returns from small-cap stocks because of the higher risks in them.

Let’s take a look at the data and see what the differences are.

The above data clearly shows that large-cap stocks have done really well over all time frames and small-cap stocks have underperformed in all time frames.

This is despite investors bearing more risk than large-cap stocks.

Here we would use two measures of risks. One is the standard deviation which represents the variability of returns and next, we will take a look at the maximum drawdowns during the 2008 crisis and during the covid selloff in 2020.

As expected, the risk measured in terms of standard deviation is lower in large caps.

There was a big difference in the way markets fell during 2008 and 2020. In 2008, markets started falling in December 2007 and kept falling for the next 12 months. During these 12 months, all the indices lost more than 50%.

During the 2020 Covid selloff, the markets fell for just about one month and then started recovering.

Please note that the drawdowns are measured month to month. Obviously, the markets fell more than the above-mentioned numbers if you see the data on daily basis. That’s one of the advantages of tracking markets over a monthly timeframe rather than on daily basis.

Till now it's quite clear that large caps have done well in terms of returns and risk. Small-cap investors haven’t really been paid for bearing excess risk.

Now let’s see how the Nifty Multicap fund compares with the Nifty Large cap fund. For this comparison, we have taken the Nifty Multicap index which has a 50% allocation to large caps, 25% to mid-cap, and 25% to small caps.

Though the last 5 years have been good for large caps but over a longer duration multi-cap has generated better returns. And as we can see below, multi-caps had the least volatility.

As we can see there are benefits of lower risk and higher returns if one chooses to invest in multi-cap funds. This benefit can be further enhanced by a good portfolio manager managing a Flexi-cap fund.

In a multi-cap fund, there is not much leeway for the fund manager in allocating to different market caps. Flexi-cap funds give a much bigger advantage to managers in removing all constraints. This however can be a double-edged sword. While a good manager can use that flexibility to generate additional returns, an average manager really won’t be able to do the job well and hence end up underperforming.

Author: Vivek Sharma, director (strategy) and head of investments at Gulaq, a part of Estee Group

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.