Newbies to the stock market need to understand, what is large-cap, mid-cap, small-cap, and market cap in stocks. The differences in growth potential and risk are shown by these categories. Small-caps have growth potential, mid-caps strike a balance between stability and expansion, and large-caps are dependable, well-established businesses.
Let’s focus on midcap and smallcap funds:
- Market Capitalization
Smallcap funds invest in companies with smaller market capitalizations, typically ranked below the top 250 in a market. The market cap threshold for small caps varies by market but is generally in the range of a few hundred million to a couple of billion dollars.
Midcap Funds invest in medium-sized companies, typically ranked between 101st and 250th in terms of market capitalization. These companies have market caps generally ranging from a couple of billion to tens of billions of dollars.
- Growth Potential:
Smallcap stocks often have higher growth potential as they are in their early growth stages. They can offer significant returns if the companies grow rapidly.
Midcap companies strike a balance between the rapid growth potential of small caps and the stability of large caps. They have the potential for growth and expansion but are more established than small caps.
- Risk Factor
The risk is higher with smallcap funds because these companies are more susceptible to market volatility and economic downturns. They are also less researched, adding to the uncertainty.
Midcap funds carry moderate risk. These companies can be more resilient than small caps but are still more volatile than large caps.
How have midcap and smallcap funds performed historically?
Mid- and small-cap funds have delivered excellent returns over a 10-year period on paper, but only some investors would have earned these published returns. There have been money-doubling years as well as years which saw 30-40% corrections. When an asset class is this volatile, it becomes challenging to remain invested without letting your emotions get in the way. The key to success with small and mid-caps is to invest with a clear understanding of the risks involved and in a disciplined manner through systematic investments rather than chasing returns or timing the market.
So, if your goals are for the long term and you understand their risks clearly, systematic investment plans (SIPs) in the small- and mid-cap space can be considered a good smart Investment.
Mid and small-caps are best suited for long-term goals. If you need the money in the next 5 years, investing in safer assets like large-caps or debt products is best. Mid- and small-caps could be a good option if you aim to retire in 20 years. However, it will help if you always prepare yourself for the volatility of these investments in the interim periods.
Risks associated with midcap and smallcap funds
- Market Volatility: Mid-cap and small-cap funds are highly susceptible to market fluctuations. This means their value can change dramatically in a short period, leading to potentially higher gains or losses. Investors need to be prepared for abrupt changes in the fund's performance.
- Liquidity Risk: These funds often invest in companies with lower trading volumes, which means that in times of market stress, it might be difficult to sell these stocks without impacting their prices significantly. This can be particularly challenging during market downturns when liquidity is crucial.
- Concentration Risk: Mid-cap and small-cap funds may have their investments concentrated in a limited number of stocks or specific sectors. This lack of diversification can increase the risk, as the fund's performance is more dependent on the fortunes of a smaller pool of assets.
The role of time horizon in midcap and smallcap investing
Mid-cap and small-cap funds are riskier than large-cap funds, but they can also offer higher returns. Over the past 20 years, mid-cap stocks have outperformed small- and large-cap stocks 60% of the time. However, small-cap mutual funds are very volatile over the short term, so they are not suitable for short-term investors.
Mid-cap funds are a good option for moderately risk-tolerant investors with a long-term investment horizon. Small-cap mutual funds can give the maximum return on your money in the long term, but they are also the riskier option. According to Investopedia, the average annual return for small-cap stocks has been 13.6% over the past 50 years, compared to 10.1% for large-cap stocks. However, it is important to note that past performance is not indicative of future results.
Analyzing the risk-return tradeoff in Mid and Small Cap funds
The risk-return tradeoff in Mid and Small Cap funds involves balancing the potential for higher returns against increased risk. These funds invest in companies with lower market capitalizations, offering growth potential but with higher volatility and risk compared to Large Cap funds.
Mid and Small Cap companies can react more sharply to market changes and economic conditions, leading to larger swings in fund value. This higher volatility can provide opportunities for significant gains, but it also poses a risk of greater losses. Investors in these funds should have a higher risk tolerance and a long-term investment horizon to mitigate the impact of short-term market fluctuations.
Smallcap v/s midcap v/s largecap v/s other investment options
Large-cap funds offer a steady and consistent return, and they have less volatility. They have provided an average return of 7% in the past 5 years.
Mid-cap fundsThe average returns of mid-caps from the past 5 years were around 10.28%. They offer better returns compared to large-cap funds.
Small-cap funds despite being the highest-risk scheme, offer very good returns. The average of the last 5 years has been 14.74%
Here’s a comparison of these 3 types of mutual funds along with a few others.
Factors Influencing Midcap and Smallcap funds
- Market Dynamics
Mid-cap and small-cap funds are highly responsive to economic trends and market shifts. Economic expansions can lead to rapid growth, while recessions may impact them severely.
- Liquidity
These funds invest in stocks with lower trading volumes, making them less liquid. This can lead to higher price volatility and challenges in buying or selling large positions without impacting the market.
- Company Fundamentals
The growth, financial health, and management quality of individual companies greatly influence fund performance. Strong fundamentals can lead to outperformance, while weaknesses can lead to underperformance.
- Sector Performance
The concentration in specific sectors can impact these funds significantly. A booming sector can boost performance, while downturns in a focused sector can lead to losses.
- Investor Sentiment
These funds are more susceptible to investor sentiment, both positive and negative, leading to rapid inflows or outflows and heightened volatility.
Tax implications and long-term gains of midcap and smallcap funds
Investing in mid-cap and small-cap mutual funds has specific tax implications, especially concerning capital gains. Long-term capital gains (LTCG) on these funds are taxed if the gain exceeds ₹1 lakh in a financial year. The LTCG tax rate for equity funds, which includes mid-cap and small-cap funds, is 10% without the benefit of indexation. Short-term capital gains (STCG), on holdings sold within a year, are taxed at 15%. For long-term gains, despite the tax, these funds can still offer attractive post-tax returns, particularly if they perform well over a longer period. This tax structure needs to be factored into investment planning and expected returns.
