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Invest in small-cap funds

Despite the high risk associated with mid-and small-cap funds, allocate a percentage of your portfolio to this category since it is bound to deliver high returns in a growth market like India

Advantages of these funds

The fact that mid- and small-cap funds outperform their large-cap peers in rising markets was evident in the bull markets of 2007, 2009, 2010 and 2012. An exposure to sectors such as education, textiles and agro-chemicals, where the players tend to be small, may not be possible via large-cap funds. So mid- and smallcap funds are your only option. Another advantage of investing in a mid- and small-cap fund, instead of the stock directly, is the guaranteed liquidity. In declining markets, exiting these stocks can prove difficult. Even if you find buyers, they will quote a low price. But if you invest through a mutual fund, you can exit smoothly on the day of your choosing.

Disadvantages & risks

While mid- and small-cap funds have the potential to outperform in a rising market, they also underperform sharply during a downturn. Bigger companies manage to weather a recession easily for one or two years. Smaller companies face a more difficult time. The sturdiness of large caps does not exist in mid and small caps. The higher volatility of these funds makes them more risky, especially for those who invest on the basis of recent performance.

Choosing the right fund

While picking a mid- and small-cap fund for your portfolio, look up its past returns. The fund should have beaten its benchmark over different time horizons. Besides a good absolute performance, you should also check whether the fund beat its benchmark in each calendar year (say, the last five). Also find out if the fund manager is good at curtailing downside risk; the fund should have fallen less than its benchmark in declining markets. Next, check the fund's risk parameters, such as standard deviation and beta. The fund should have a lower level of risk than its category average. In addition to the above criteria, go through the following aspects that are specific to mid- and small-cap funds.

Asset bloat: The AUM (assets under management) size matters a lot in case of mid- and smallcap funds. As a fund's corpus bloats, the fund manager needs to find more good stocks, but that many options may not be available. He may be forced to invest more money in the same stock. This can lead to, what is known as, a higher impact cost. When a large fund invests a lot of money in a single stock, especially one that is less liquid, its purchases drive up the stock's price. This could result in a significant difference between the prices of the first and the last stock that are purchased.

Sometimes when a fund's asset size grows, it moves into the large-cap category, which alters its character. It no longer fulfills the purpose for which it was originally included in the portfolio. Check whether the fund has a policy of closing down fresh investments to guard against the problem of asset bloat. IDFC Premier Equity is one fund that is known to do so consistently.

Concentrated or diversified: In the mid- and small-cap space, it may be advantageous to go for funds that are diversified. If corporate governance and disclosure standards are not too high and stocks are tracked less closely, one way to reduce risk is to go with funds that are reasonably diversified.

Passive funds: A case for investing in passive funds exists in the mid- and small-cap category because the fund managers change frequently here. Another reason is that mid-cap indices tend to be broad based. For fund managers to build a portfolio that can beat such indices is more difficult. The third reason in favour of investing in passive funds is that expense ratios tend to be lower, and this can make a significant difference in the returns that are delivered over long time horizons.

Most of the passively managed funds in the mid and small-cap category are based on the Nifty Junior index. So, by investing with a long time horizon of, say, three to five years, and rebalancing regularly, you can enjoy the high returns of these funds, while curtailing their risks significantly.

Happy Investing!!

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