Investing in mutual funds requires the balancing act. Should you invest in large-caps, mid-caps or small-caps? For those who don’t know, ‘cap’ means market capitalization or the size of a listed Company. For the fund manager, the size of the Company is an important factor while picking stocks for an equity mutual fund.
Large-cap funds invest most of the corpus in Companies of high value or large market capitalization. These are reputed well-established Companies with steady earnings and a track record of performance. Mid-caps fall between large-caps and small-caps in terms of Company size. Mid-cap funds invest in high growth Companies, which seek rapid expansion. Small-cap funds invest in relatively young, highly aggressive, small-sized Companies. Take a look at 5 factors which help decide on mutual fund categories.
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Risk profile is the ability and willingness to bear risk. A conservative investor must consider large-cap funds. They generate wealth, slowly and steadily over the long term. These are steady performers which pay regular dividends. Large-caps have performed very well over the last year, even as mid-caps and small-caps are going through a severe correction. A volatile market has forced investors to seek solace in large-cap funds.
Mid-caps and small-caps are for investors with high risk tolerance. They outperform large-caps in a bull market, but could crash in a bear market. Small-caps are for investors with high risk appetite, seeking very high returns.
Total Expense Ratio (TER) is the expenses involved in managing and operating the fund. Studies have shown that mutual funds with lower expense ratio generally outperform those with higher expense ratio. Large-caps have lower expense ratio vis-à-vis mid-caps and small-caps, as expenses are spread over a fund of very large size. Mid-caps and small-caps have a higher expense ratio as they meet expenses over a smaller asset base.
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Time horizon is the time you can stay invested in a mutual fund. Invest in equity mutual funds for the long-term of at least 5-7 years. Studies have shown that 10-year returns of small-caps are higher than large-cap funds over the same period. Small-caps are good performers even over a 5-year period. The trick of making money in any mutual fund is staying invested for the long-term. Invest in small-caps over large-caps and even mid-caps, if you have a time horizon of 10 years or more.
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Investing in small-caps is not just the volatility. Good research cuts down risk in small-caps, which is beyond the scope of first-timers. It would be wise for first-timers to stick to large-caps. If you are not capable of Do It Yourself investing, stay far from mid-caps and small-caps. They are not meant for everyone. A first-timer who invests in a small-cap and sees the portfolio erode by 15-20% would panic and exit the scheme, never reaching financial goals.
Diversification is not investing in two mid-caps and two small-caps. Diversify across categories. First-timers could invest in one large-cap, mid-cap and small-cap.
One fund category that stands out is multi-cap funds. They are equity diversified funds which invest in Companies of different market capitalization.
Multi-cap funds have been exceptional performers over the past year. They don’t face restrictions vis-à-vis Company size. A large-cap has to invest only in large-cap Companies and a small-cap in small-cap companies. Multi-cap funds have the opportunity of investing across markets. Invest in multi-caps if you are a moderate risk-taker looking for long-term wealth creation.
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