Mid cap and small cap funds are equity mutual funds that invest in companies falling below the large cap segment in terms of market capitalisation. While they may seem similar at first glance, mid cap and small cap funds have some key differences that investors should be aware of. Read on as we compare mid cap and small cap mutual funds across various parameters to help you make an informed investment decision.
Overview of Mid Cap and Small Cap Funds
A mid cap fund invests predominantly in the stock of mid-sized companies that are ranked from 101 to 250 by market capitalisation based on the SEBI classification. Mid cap companies are smaller than well-established large cap companies but bigger than small caps.
On the other hand, a small cap fund allocates most of its assets to smaller companies that are ranked 251 and beyond by market capitalization. These companies are in a nascent growth phase and often operate in niche segments.
While the market cap range defines the universe of stocks for each category, the portfolio composition and stock selection strategies also vary. Let us look at some key differences between these fund types.
Comparing the Risk-Return Potential
Risk and return go hand-in-hand for equity funds and a higher return potential comes with a higher risk exposure as well.
Mid cap funds carry relatively high risk compared to large caps as they invest in smaller companies. However, mid caps are more established and stable when compared to small caps. Thus, mid cap funds offer a higher return potential than large caps (albeit at a relatively higher risk), but a lower return potential than small caps (albeit at a relatively lower risk).
On the other hand, small cap funds generally involve higher volatility because companies in the small cap segment may experience sharper price movements and are more sensitive to economic and market changes. However, the trade-off of the very high risk is the potential for very high returns. Thus, while small cap funds offer the potential for outperformance, they are also extremely vulnerable to volatility.
Small caps aim to offer greater upside potential but also carry higher downside risk compared to mid caps. Meanwhile, mid cap funds can be a middle path suitable for investors who desire a better return potential than large caps, but with relatively lower risk than small caps. One must always evaluate one’s risk appetite before choosing between these two categories.
Ideal Investment Horizon and Goals
Investment horizon is a key determinant of which fund category may be more appropriate for investors.
Mid cap funds can be suitable for investors with a relatively mid-to-long term investment horizon of at least 5-7 years. The longer holding period allows sufficient time for mid cap companies to realise their growth potential and investors to benefit from the uptrend. Hence, mid caps may potentially play a key role in a portfolio targeted towards long term wealth creation goals.
Small caps require an even longer time frame of at least 7-10 years. This provides leeway for smaller companies to establish themselves and become attractive acquisitions targets or eventually transform into mid/large caps. So, small caps align better with very long term goals of 10 years or more. The extended horizon also allows small cap returns to smoothen out interim volatility periods.
Investors should ideally stay invested through business cycles and not attempt timing the market. Hence, investment goals requiring a shorter 3-5 year horizon may be better suited to mid cap funds, while a 7-10+ year horizon may be more suitable for small cap funds.
Advantages and Drawbacks
- Mid cap funds offer some potential advantages:
- Relatively high growth potential compared to large caps
- Relatively lower volatility than small caps
- Exposure to emerging themes and sectors at an early growth stage
- Scope for diversification as mid cap universe is broader than small caps
However, they also have some drawbacks:
- Prone to volatility compared to large caps
- Not as high growth potential as small caps in strong bull markets
- Relatively lower liquidity than large cap funds
- On the other hand, small cap funds have these advantages:
- Potential for better returns owing to higher business risk
- Provides exposure to companies operating in niche or emerging segments.
- Adds diversification to a portfolio heavy on large caps
- Benefit from India's entrepreneurial growth story
But the limitations are:
- Prone to very high volatility, so higher downside risks
- Low liquidity in the segment leads to higher impact costs
- Requires longer investment horizon of 7-10 years
- Concentration risk as the universe of companies is small
Weigh both the pros and cons before deciding between mid cap and small cap funds for your portfolio.
Summary
While both mid cap and small cap funds are high-risk equity instruments, they cater to different investment horizons and risk-return objectives. Mid caps can offer a middle path for investors seeking better returns than large caps with lower volatility than small caps. Small caps may be more appropriate for highly aggressive investors with very long term goals who can withstand pronounced volatility. Evaluate parameters like your risk tolerance, ideal investment tenure, liquidity needs and goal timeframe. Both categories can aid in diversification and add growth potential for investors with the right outlook and horizon. It is usually prudent to have a balanced allocation between large, mid and small cap funds based on your individual profile and requirements.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.