Midcap Category – riskier than largecaps but outperform over long runDocument Transcript
Retail Research 1Midcap Category – Riskier than largecaps but outperform over long run June 10, 2013In this note, we state some of the findings of a study carried out on Equity Diversified mutual fund schemes by comparing the risk andreturns generated by the Largecap and Midcap schemes.Key findings:1. The risk of Midcaps, as measured by annual Standard Deviation of returns, is higher than the largecaps at any point of time.2. Analysts belonging to the fund industry follow different calculation methodologies to arrive at Standard Deviation figures (tomeasure the risk of a scheme or index). In other words, the returns data points that are used for calculating StandardDeviation vary among analysts.3. The Annualized Standard Deviation calculated based on daily rolling returns showed that largecaps carry higher risk thanmidcap while the calculation based on the data points like 1 month, 3 month, 6 month or 1 year rolling returns showed thatmidcaps carry higher risk than largecap.4. The lower risk shown by midcaps over largecaps as measured from daily returns (see the chart 1) is probably due to circuitfilters that applicable for midcap stocks coupled with wider movements of largecap stocks on the back of concentratedconstituents in the barometers and lesser liquidity in Midcaps (compared to largecaps) resulting in spreading of sales and buysover a period of time. On the other hand, the calculations that are based on 1 month, 3 month, 6 month and 1 year returnsdisplay the true picture of high risky profile of midcap stocks thus proving the higher volatile nature than largecap counterparts(see the chart 2,3,4 & 5).5. This is the trend seen not only between Largecap and Midcap mutual fund categories but also between the CNX Nifty andCNX Midcap indices.6. Between Sensex and Nifty, Sensex carries marginally higher risk than Nifty given its concentrated stock constitution (30 stocksvs 50 stocks). The CNX 500 carries higher risk than Nifty but lower risk than CNX Midcap.7. As far as the returns part is concerned, the midcap funds outperformed largecap funds over the longer duration say for theinvesting periods of nine years and more (See the chart 7). They underperformed Largecaps in the short and medium term.Meanwhile, as far as SIP investments are concerned, the Midcap funds outperformed largecap schemes for the investingperiods of 5 years and more (see the chart 8).In mutual funds, one of the main risks pertain to volatility. Volatility is the fluctuation of the NAV over the defined period. Standarddeviation is used to measure the volatility of the schemes. It reflects the consistency of performance. Standard Deviation gives you agood idea if you can tolerate an investment’s ups and downs. The higher this number, the more likely you are to experience dramaticmoves in either direction. Example: Standard deviation of 10 means an investment averaging 10% annual returns has historically (forabout 68% of the sample size) ranged from –0% to +20% each year. In a nutshell, a higher standard deviation implies greater volatilityor risk.For our study, we have considered last 10 years data say from May 2003 to May 2013 to measure the risk in the indices. To measurethe risk in the mutual fund categories, we considered last 5 years data (from May 2008 to May 2013). We calculated AnnualizedStandard Deviation in five different ways using daily rolling return, 1 month, 3 month, 6 month and 1 year rolling returns. The findingsare charted below.Midcaps carry higher risk than Largecaps:The following charts compare the risks generated by Sensex, Nifty, CNX Midcap and CNX 500 over the last ten years period (from2003 to 2013). The Chart 1 shows the Annualized Standard Deviation data that are calculated from indices’ daily rolling returns for last10 years period. Likewise Chart 2 shows the Annualized Standard Deviation data which are calculated from one month rolling returns ofthe indices for last 10 years period.From the following charts one can observe that the Sensex and Nifty showed higher risk than CNX Midcap in the chart 1, while the CNXMidcap show higher risk than Sensex and Nifty in the rest of the charts (charts 2,3,4 and 5).In the chart 1, the largecap indices – Sensex and Nifty saw carrying higher risk compared to CNX Midcap which was mainly attributableto applicable circuit filters to the midcap stocks in the exchanges coupled with the wide movements of largecap stocks on the back ofconcentrated constituents in the respective barometers and lesser liquidity in Midcaps (compared to largecaps) resulting in spreading ofsales and buys over a period of time.Hence, higher volatility in the midcap stocks results in carrying higher risk than largecap. The same is shown in the charts 2,3,4,and 5.
Retail Research 2Chart 1: Risk as measured by Annualized SD based on Daily Rolling Returns. (Largecap seem to be carrying higher risk)Annualized Standard Deviation based on Daily Rolling Returns for last 10 years period3426 25 250510152025303540Sensex Nifty CNX Midcap CNX 500Chart 2: Risk as measured by Annualized SD based on 1 month Rolling Returns. (Midcap witnessed carrying higher risk)Annualized Standard Deviation based on 1 month Rolling Returns for last 10 years period27 2731280510152025303540Sensex Nifty CNX Midcap CNX 500Chart 3: Risk as measured by Annualized SD based on 3 month Rolling Returns. (Midcap witnessed carrying higher risk)Annualized Standard Deviation based on 3 month Rolling Returns for last 10 years period39 3845410102030405060Sensex Nifty CNX Midcap CNX 500Chart 4: Risk as measured by Annualized SD based on 6 month Rolling Returns. (Midcap witnessed carrying higher risk)Annualized Standard Deviation based on 6 month Rolling Returns for last 10 years period33 32393501020304050Sensex Nifty CNX Midcap CNX 500
Retail Research 3Chart 5: Risk as measured by Annualized SD based on 1 Year Rolling Returns. (Midcap witnessed carrying higher risk)Annualized Standard Deviation based on 1 Year Rolling Returns for last 10 years period312939320153045Sensex Nifty CNX Midcap CNX 500Another main reason for higher risk shown by Sensex and Nifty in the Chart 1 is the concentrated constituents in the respectivebarometers. The number of constituents in the Sensex and Nifty are 30 and 50 while the number of constituents in the CNX Midcap is100. Such diversification in number of constituents plays important role in mitigating the volatility. In other words, the top 5 constituentshave 40% and 33% weight in Sensex and Nifty while in CNX Midcap these have 17% weight in the index. It is worth noting that sectorconcentration also plays considerable role in this case.Table 1. Concentration analysis:Particular Sensex Nifty CNX Midcap CNX 500LargecapMF categoryMidcap MFcategoryTop 5 stocks / median Top 5 holding 39.96% 33.31% 17.00% 21.35% 31.26% 21.82%Top 10 stocks / median Top 10 holding 62.04% 51.71% 28.29% 33.15% 49.92% 37.31%No. of constituents / Median no. of constituents 30 50 100 500 36 45Note: Indices data are based on June 04, 2013. Mutual funds data are based on last five year periods.Risk in Mutual Fund largecap and Midcap categories:The same trend witnessed in mutual fund categories also (see the chart displayed below). The midcap category showed lower risk if theStandard Deviation is calculated from Daily returns while the midcap funds showed higher risk if the calculation is based on monthlyand other periodicity.To conclude, the midcap categories carry higher risk than largecap categories.Chart 6. Risk in Largecap and midcap categories:23262933292230374140051015202530354045Ann SD based on daily rolling returns Ann SD based on 1 Month rollingreturnsAnn SD based on 3 Month rollingreturnsAnn SD based on 6 Month rollingreturnsAnn SD based on 1 y ear rollingreturnsLargecap Category Midcap CategoryReturns:As far as the returns generated by the largecap and midcap schemes are concerned, considering the rolling returns the different timeframes (rolling return calculated for the scheme from the last 10 year data), largecap schemes witnessed outperformance for 7 yearperiods while the midcaps saw outperformance for 9 years and above. In the case of SIP investments, midcap schemes witnessedoutperformance for the periods of five years and above.
Retail Research 4From the above points one can conclude that Investments through staggered modes such as SIP is highly advisable in midcapschemes given their high risk profile nature. A small exposure to SIP in midcap scheme can be taken by any kind of investors and runfor minimum five years period. However, the investors have to be careful on choosing funds for the investments. Periodical review ofportfolio (at least twice in a year) can help to reshuffle out of persistent laggards.Chart 7. Performance of Largecap and midcap schemes: (Rolling Returns calculated from last ten year data)0510152025301 Year 2 Years 3 Years 5 Years 7 Years 9 Years 10 Years 12 YearsLarge cap Mid capChart 8. SIP Returns (XIIR):05101520251 Year SIP 2 Year SIP 3 Year SIP 5 Year SIP 7 Year SIP 9 Year SIP 10 Year SIP 12 Year SIP 13 Year SIPLargecap MFcategory Midcap MFcategoryThe schemes within the category vary in different aspects which may also impact the risk and return of the overall category. Some ofthe factors that includes such as investment objective, benchmark they track, turnover ratio, expenses ratio and so on.Midcap stocks are high beta stocks and respond faster than large caps to the market information. They have higher return potentialcompared to large caps. They have better growth prospects due to presence in a new segment/ area that is growing at a faster pace.They have ability to gain share due to new technology, better product / service etc. They have smaller base of revenues and profits;hence growth rates can be larger. Floating stock may be limited; hence small demand for stocks results in more than proportional rise inprices. There is a room for P/E multiples to expand if the company transitions from a small / mid cap to large cap, etc.As far as large cap companies are concerned, the growth is lower in comparison to the period when they were mid cap companies asthey are there in the relatively early stages of their business life cycles and their base was smaller. Midcap stocks also offer investorsopportunities to capitalize on merger and acquisition activity as some attractive businesses have the potential to be acquired by largerfirms. Small and Midcap companies offer higher return potential than large cap companies and also carry higher risk than large capcompanies, particularly over the short and medium term.This report is in continuation with our earlier report (Equity markets nearing a bottom - Can one start SIP in midcap funds?), which alsoelaborated on the lower risk and higher return nature of mid cap mutual fund schemes over the large caps counterparts.
Retail Research 5Analyst: Dhuraivel GunasekaranRETAIL RESEARCH Fax: (022) 3075 3435Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. CromptonGreaves, Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.comDisclaimer: Mutual Funds investments are subject to risk. Past performance is no guarantee for future performance. This document has been preparedby HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or madeavailable to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein isfrom sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time totime positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, orother services for, any company mentioned in this document. This report is intended for non-Institutional Clients.