Cautious investors may shift to an index fund in mid-, small-cap categories

The new fund offer (NFO) of ICICI Prudential Smallcap Index Fund is on at present (it closes on October 26). In recent times, many index fund options have become available within the mid- and small-cap space from fund houses like Aditya Birla Sun Life, ICICI Prudential, Nippon India, Motilal Oswal, and so on. In the large-cap space, the consensus among financial planners has swung in favour of passive funds. In the case of mid- and small-cap funds, however, that is not so yet. So, what should your strategy be? Should you stick to active funds in this space, or is it time to make the switch to passive funds?

Long-term outperformance

Most advisors refer to the SPIVA (S&P Indices versus Active Funds) India scorecard when trying to decide their position on the active versus passive debate.

A look at the latest report for mid-2021 shows that nearly 66 per cent of large-cap active funds were outperformed by the index over the 10-year horizon. In other words, only 34 per cent of these funds outperformed.

The evidence against active funds is less overwhelming in the mid- and small-cap category. Over a 10-year period, 40.3 per cent of active funds were outperformed by their benchmark, that is, 59.7 per cent outperformed. “The long-term performance of active funds in these categories is still decent,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

A few issues

However, there are a couple of points that one should note. “The SPIVA report (for mid-2019, when it last had a data point on style consistency) showed that 74 per cent of midcap-smallcap mutual funds either got merged into other funds or had changed their categorisation over the past 10 years. Hence, there is insufficient statistically significant data to draw robust conclusions,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

Running a mid- or small-cap ETF is likely to be harder than running a large-cap ETF. “The mid- and small-cap categories have lower liquidity and hence higher impact cost. Tracking error could be higher in these categories. That is one thing to watch out for,” says Raghaw.      

In the mid- and small-cap categories, issues like poor quality management and poor governance standards tend to be more pronounced. Active fund managers can add value by filtering out the stocks that rate poorly on these parameters.  

What should you do?

Going with an active fund is always a double-edged sword. These funds can outperform but they can also underperform. Even if the majority of mid-small-cap funds have outperformed their indexes in the past, there is no guarantee they will continue to do so in the future. And it is nearly impossible to predict which active fund will outperform in the future. With an index fund, you are assured of getting returns that match the index.    

Those with a higher risk appetite may stick to active funds. More conservative investors may opt for passive funds in these categories.  

If you go with a passive fund in the mid- and small-cap space, stick to an index fund and avoid ETFs. “Most of the mid-/small-cap ETFs have small AUMs and are unlikely to have adequate liquidity,” says Luthria. Lack of liquidity can result in issues like deviation of the ETF’s market price from its net asset value (NAV), which can cause losses to the investor.

When selecting an index fund, pay attention to fee and tracking error (lower is better in both cases).

Also, watch out for fee hikes in the future. “In categories where competition is low, there is the risk of the fund house hiking the fee in the future. This is unlikely to happen in the Nifty 50 category where there is immense competition,” adds Luthria.

Fund sizes are small
Fund	AUM (Rs crore)
Motilal Oswal Nifty Midcap 150 Index Fund	357.8
Nippon India Nifty Midcap 150 Index Fund	177.0
Aditya Birla Sun Life Nifty Midcap 150 Index Fund	53.1
Aditya Birla Sun Life Nifty Smallcap 50 Index Fund	39.5
Motilal Oswal Nifty Smallcap 250 Index Fund	220.6
Nippon India Nifty Smallcap 250 Index Fund	212.5
Costs are low
Fund	Expense ratio (%)
Motilal Oswal Nifty Midcap 150 Index Fund	0.2
Nippon India Nifty Midcap 150 Index Fund	0.2
Motilal Oswal Nifty Smallcap 250 Index Fund	0.3
Nippon India Nifty Smallcap 250 Index Fund	0.3
Figures are for direct, growth plans
Source: MFI Explorer