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#BQMutualFundShow: Before You Invest In A Mid-Cap Fund, Ensure It Ticks These Three Boxes

Superior quality, right size and true to label. Investors should any ensure that any mid-cap fund they put money in tick these boxes, said Radhika Gupta, chief executive officer at Edelweiss Mutual Fund.

Besides a high-quality portfolio, investors should also ensure they stick to “clean mid cap,” she said on BloombergQuint’s weekly series, The Mutual Fund Show. “If you are buying mid cap, then don’t buy small and large cap.”

The third criterion – the right size or liquidity – is especially critical for mid-cap funds since in a weak market, smaller companies will likely do worse and investors will redeem from these funds, she explained. “The fund, if it is too large and not liquid enough, will not be able to sell those positions quickly and will be hit with losses.”

Here are edited excerpts.

You were saying mid caps are not expensive.

I love this rhetoric around mid caps that they are very expensive. But expensive in comparison to what? The standard comparison you get when it pertains to mid-cap funds is, mid caps are expensive versus large caps. As if it is a birthright that large caps have to be traded at some kind of premium to mid caps.

The challenge is that investors compare the large-cap index to mid-cap index. They look at valuations of the two indices and say mid caps are more expensive, without realising that you are comparing apples and kiwis. For example, the Nifty is 35 percent banking, the mid-cap index is 20 percent banking.

They are not comparable indices. You can’t compare 20 percent banking with 35 percent banking. When you have to do the comparison, then do it on a stock or a very narrow sector. You will realise that mid caps are not as expensive.

When you have to do the comparison, then do it on a stock or a very narrow sector. You will realise that mid caps are not as expensive.

Also mid caps are not so risky. Some of the mid-cap businesses are fabulous businesses.

Risk is not a function of size. Risk is a function of quality of business. There is a perception that mid caps are risky. There are quality mid-cap businesses and there are poor mid-cap businesses. Also, there are very poor large- and small-cap businesses. Mid caps are smaller today because of the size of the market or the opportunity that may exist today. But hopefully with India’s growth, they will become significantly larger.

For instance, Eicher Motors Ltd. or IndusInd Bank Ltd. were smaller opportunities ten years ago, as a market which have now become larger and hence the mid caps have become large caps. But quality mid caps are not risky.

“Risk is not a function of size. Risk is a function of quality of business.”

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You are saying that there is this myth of valuations of mid caps. Why do you say there is a myth because arguably when we look at the mid-cap or small-cap index and the price-to-earnings, that’s not cheap.

I agree, and nothing in equity market is cheap by any metric today. When you look at large-cap investing, the index is a very relevant thing to do. Mid caps are not an index play. If you start with the mid-cap index, it has its own share of issues, but most people who run mid-cap funds are essentially looking to bottom up buy individual indices. In our mutual fund portfolio, we are really looking at bottom up indices, we take very very high active weights or deviations from the index when we build the portfolio. That’s why I say looking at index is not important but look at individual businesses where you see value. That’s where a mid-cap manager will add value.

How do we choose good mid-cap funds?

There are 3-4 interesting criteria that you can look at. One is the quality of the portfolio which is of supreme importance. If you are investing in mid caps, you have to look at very high-quality portfolio. Mutual funds disclose their portfolio as per norms on the website. Look at that.

Secondly, SEBI’s new guidelines makes it easier, that it should be a genuine and true-to-label mid-cap fund. If you are buying mid cap, then don’t buy small and large cap. Look for clean mid cap.

The third criteria, that’s very important and not talked about enough, is liquidity.

If markets are bad, smaller companies will tend to do worse, investors will redeem from the fund and the fund, if it is too large and not liquid enough, will not be able to sell those positions quickly and will be hit with losses. So, a mid-cap fund needs to be of the right size.

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And what is the right size?

One of the things that we try to monitor, and it is not too specific to our fund, is the liquidity. If I need to exit my portfolio in reasonable market conditions, how many days will it take? There are funds where the answer would be 900 days. That is probably the fund that is too large in size. There are funds whose answer is 10-20 trading days. The nicest thing which I learned in the 2008 crisis in the U.S. is if something is too big to fail it usually does fail. I think with mid cap, the right size is important.

Is there number to this right size? How does an average investor do it?

It is hard to put number to it. I think when you are looking at funds in the ballpark of Rs 1,000-5,000 crore in the mid cap category on a liquidity basis, then that broadly is a good size to be at given India’s market conditions. It is not a scientific answer. But a lot of fund houses are now publishing liquidity analysis of their portfolio. Lot more people are talking about it because we have experienced 2008 and 2011.

If you are investing for a time frame longer than five-seven years, are mid-caps funds as safe as any other funds?

It is. It is very important to talk about the worst-case outcome that someone has in a mid-cap fund. If you are invested for a three-year rolling period, and we have a 10-year history, the worst case outcome you would have had is negative 2 percent in mid-cap fund. I suspect that if I would have done the analysis for 5-year horizon, the worst-case outcome would be positive. The worst-case outcome over three years, the chance of earning less than 8 percent return, was 15 percent. That’s not a bad outcome. The key is the time horizon.

Also Read: ‘Invest In Equity Mutual Funds For At Least Three Years’

Watch the full interview here.

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