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It has been a torrid year for mutual fund investors. While returns from large- and multi-cap funds have been poor, mid-cap funds have given a tepid performance and small-cap funds fared marginally better year-to-date (YTD) in what has turned out to be a bleak year for equity funds (see table).
Why the divergence?
One reason for the poor performance of large- and multi-cap funds is that corporate profit growth has been poor in the three quarters. "In the first three quarters of this year, profit growth for the index was flat or negative," says Gautam Sinha Roy, fund manager, MOSt Focused Multi-cap 35 Fund.
Many companies were trading at expensive valuations at at the beginning of 2015. Those were the very companies that registered good earnings growth during the year. Even if fund managers picked the right stocks with good earnings growth, stretched valuations meant that returns from them were not high. Besides, the poor performance of sectors like commodities, public sector banks and metals acted as a drag on fund performance. "Stock price movement takes place either due to earnings growth or price-to-earnings expansion (P/E). This year earnings growth has been flat or negative and PE ratios have come down or at least not expanded," says Sinha.
The scenario was different for the mid-cap and small-cap categories. According to Vinit Sambre, fund manager, DSP BlackRock Micro-cap Fund, "There were huge inflows into the mid- and small-cap categories in 2014, which had outperformed the large-cap category. This trend continued even in 2015, helping the category to outperform."
After the change of government in May 2014, the consensus view was that there would be a fast-paced recovery within the Indian economy. "When an economic recovery takes place, mid- and small-cap companies, which were stressed during bad times, tend to benefit more and their stock prices move up sharply. These stocks benefited from the expectation of a sharp recovery," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Mid- and small-cap stocks (and hence funds) also benefited from the RBI's rate cuts over the past year and the expectation that rates will soften further in 2016.
If you look at longer-term data, in 2013 mid- and small-cap stocks had underperformed large-caps. "Part of the run-up in these stocks and funds since 2014 may be attributed to the bounce back from past lows. A kind of catching up has taken place," says Dhawan.
The performance of the large- and the multi-cap category will depend on earnings growth. With the Sensex trading at a PE of around 18 times March 2016 earnings, valuations are not cheap. So, earnings growth will have to gather momentum for these stocks, and hence funds, to perform well.
The macro factors that could facilitate higher earnings growth have been in place for some time now: interest rates are heading down while the Wholesale Price Index inflation and the twin deficits have been under control for some time. Some of the high-frequency data like auto sales, sales in some consumer categories, airline traffic, cement and power consumption have all seen an uptick in the past month or so. "We believe that we are witnessing the green shoots of recovery. Earnings growth will rebound, led by demand growth, low commodity prices and lower interest rates. This will lead to an improved performance by large- and multi-cap equity funds next year," says Roy.
Valuations of mid- and small-cap stocks are at a premium to large caps. The outlook for global growth has become weaker over the past three-six months because of the slowdown in the Chinese economy and deflationary trends in Europe. The Fed rate hike, widely expected to happen on December 16, could usher in volatility in emerging markets.
Some small-cap funds have imposed caps on the amount of money that investors can invest in a day, which indicates that fund managers don't want large and sudden inflows. This is because they don't see enough opportunities for deploying new money at attractive valuations, and don't want to sit on large piles of cash in their funds. Investors should treat this as a warning and avoid being overweight on the mid- and the small-cap categories.
What should you do?
Often people invest by looking at past returns. "When they look at 2015 returns, they will see that the mid- and small-cap fund categories have outperformed large caps. There will be a tendency to put more money into those funds. But you need to be cautious because valuations are at a premium in the mid- and small-cap space," says Dhawan.
Investors should also try to fortify their portfolio against the volatility expected to arise from the Fed rate hike. "When high volatility is expected, you should take refuge in large and multi-cap funds rather than be overweight on mid- and small-cap funds," says Dhawan.
A typical portfolio should have 70-80 per cent allocation to large- and multi-cap funds and 20-30 per cent in mid- and small-cap funds. Due to the outperformance of mid- and small-cap funds, their weightage in your portfolio would have increased. Prune your exposure to these funds. Besides, since mid- and small-cap funds are trading at a premium to large-cap funds, and a lot of volatility is expected in the near term, you may bring down the allocation to the former category to 15 per cent of your portfolio. Once the volatility on the global front has subsided, you may bring your mid- and small-cap allocation back to 30 per cent six months or one year later.
At the same time, don't quit the mid- and small-cap categories entirely due to fear of interim volatility. As Sambre says: He suggests that investors should invest in these categories with at least a three- to five-year horizon. Hence, continue to have some allocation to these funds to benefit from their next upsurge.
