Last Updated on December 29, 2021 at 12:01 pm
Many young mutual fund investors assume that their portfolios should have more of mid cap and small cap stocks or mutual funds because these will outperform large caps over the long run. As usual, such assumptions are based on “intuition” without rigorous data support. In this post, let us compare large cap, mid cap and small cap indices to find out what kind of mix is suitable for a long term investor.
Before we begin, there are several factors and limitations to be understood. To compare large cap funds with mid cap funds and small cap funds, we can only choose benchmark indices are not the actual active funds themselves. This is because if we want the best funds in each category, the analysis will suffer from survival bias. If we choose for the worst funds in each category, the study will suffer from confirmation bias! If we select all funds in each group, then we would end up with sampling issues and time issues as there are only a handful of 20Y+ large cap funds and few reasonably old mid cap funds and only young small cap funds.
This makes comparison quite tricky. So the only meaningful way is to choose benchmark indices that best represent each category. First, let us discuss results for Indian indices and then find out the situation in the USA. I am thankful to a friend who prefers anonymity for providing me with the US mid cap and small cap index data for this analysis.
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The following flowchart tells you how the NSE indices are classified. For more details, you can watch my talk on index investing: Can we get higher returns with lower risk?
For this study, we shall use Nifty 100 for large cap, Nifty Midcap 150 for mid cap and the Nifty Small cap 250 for small cap stocks. They represent the top 100, middle 150 and bottom 250 shares of the Nifty 500. We will now look at the rolling returns of these indices for different durations.
What is a rolling return?
To understand what a rolling return is, why it is essential for investors, please check this out.
Large Cap vs Mid Cap vs Small Cap: 5 years (Indian markets)
So let us start with five years. Please recognise we do not have enough “long term” data, so we will work with what we have.
I have added the Nifty Next 50 (the bottom 50 of Nifty 100) also for comparison as Nifty Next 50 is a benchmark Index that no active mutual fund would touch! This is not a large cap index as I have warned earlier and is as risky and as rewarding as a mid cap index. Please take some time to observe each graph.
Over five years, there is not much to differentiate among the market cap categories. This is an extended graph:
Over five years it is not possible to expect one market cap to beat another. It is merely potluck and sequence of returns.
Seven years
Did you notice how Nifty Next 50 (NN50) has a prominent (if not dominant) position? Small cap fans should understand that “long term” is not seven years!! The following is an extended chart.
Notice that even over 7y, NN50 returns can be comparable to N100 returns. N100 will have a return a tad higher than the Nifty 50 (due to market cap based weighting).
Ten years
Now, keep an eye on the number you see in the grey box: 914. These are the number of data points. Our indices are so young that even for ten year periods, there only so few points. If we increase the duration from 10 to 15, the number will dramatically drop. Lower the amount of data points, the less confident we can be about any conclusion drawn. Never forget this!
It is amusing to see the NN50 beat the Nifty Midcap 150. Look how disappointing the small cap index performance is. It is reasonable to assume that over 10Y and above, mid caps will outperform the large caps.
However, the NN50 (currently classified a large cap by SEBI and others) is also a mid cap (classification should be regarding risk, see above warning post). The NN50 is a better quality midcap index IMO than the Midcap 150.
Why have the small caps failed? When we assume small cap portfolio will beat a large cap portfolio, we also believe that many of the small cap stocks will become multi-baggers and go on to become a mid cap first and then a lareg cap. This is not the case. Not enough of them make the transition.
On the other hand, mid caps have done better. The mid cap companies have crossed the small cap barrier. So one can expect more mid caps to become large caps than small caps. Of course, this is a pretty crude explanation but should suffice for a start.
By the same token NN50 stocks have overcome two barriers and have just one step away from becoming large caps. Since there are only 50 of them in the index, the selection is also tighter.
The above graph is the reason why I believe index investors do not need a separate actively managed midcap or small cap fund in their portfolio. A portfolio of 50% Nifty 50 and 50% Nifty Next 50, which I call the NIfty blend, is all that is necessary. See: Can I start Index investing with 50% Nifty 50 and 50% Nifty Next 50? And also What is the best way to invest in Nifty Next 50 Index?
Fifteen years
This is what I mean by lack of enough data. Go to 15Y, and there are no midcap and small cap data points. 
The NN50 has comfortably outperformed the N100 but notice that the margin of outperformance has been coming down. They don’t say past performance is not an indicator of future returns for nothing!
What about Nifty 100 Equal Weight?
This index consists of 100 stocks from N100 with equal weight. Two index funds from Principal and Sundaram are available as options for investors. Those who do want to choose such low AUM index funds can work instead with the NIfty Blend: two index funds: 50% of Nifty 50 and 50% Nifty Next 50. We will call this Nifty Blend (50:50)
That is pretty decent I would say. This is a good option for those who do not want the high volatility of Nifty Next 50.
What about Nifty Blend (50:50): 50% N50 + 50% NN50?
As mentioned earlier, the 50:50 blend is pretty much a proxy for N100 Equal Weight.
What about Nifty Blend (40:60): 40% N50 + 60% NN50?
What about Nifty Blend (30:70): 30% N50 + 70% NN50?
You can, adjust the blend as per your risk appetite (which will be known only when you suffer a big loss).
Large Cap vs Mid Cap vs Small Cap: 5 years (US markets)
The US market is a lot wider and deeper. The S&P 500 is a large cap index. Also, there is an S&P 400 Mid cap and S&P 600 small cap indices The mid cap and small cap indices are relatively recent in comparison.
Over five years, there is not much to say among the categories.
S&P 500 vs S&P 400 Midcap vs S&P 600 Smallcap (10 years)
Notice that there 4000 data points here compared to only 900 data points for Indian Indices. What we fail to understand is, “lack of enough data points” is a perfectly logical and technical conclusion. We must get rid of our compulsion to conclude something from everything that we see.
The mid cap index has done better here, but the small cap index fails to impress. Why would anyone take on more risk than mid caps only to get the same return?
S&P 500 vs S&P 400 Midcap vs S&P 600 Smallcap (15 years)
Again, pretty much the same conclusion as above for ten years. It makes sense to have more midcap for a genuinely long term portfolio but no small caps.
20 years
The mid cap outperformance is much cleaner here. The small cap TRI data is not available that far back (on a daily basis) and hence was not used.
Video version
Conclusions
So what can we learn from Large Cap vs Mid Cap vs Small Cap study of Indian and US markets? First, let us consider the failure of broad market small cap indices. It is quite likely that this is because few small caps go on to become multi-baggers as explained above. What smallcap gain during a bull run, they lose during a sideways movement or crash and this averages out to a poor performance. With midcaps, the stocks have probably lived through a difficult phase, and at least some of them have a chance of becoming large caps.
One can argue that actively managed Indian mid and small caps can do better. Sadly that is not the case: Why we badly need a Midcap & Smallcap Index Fund: Performance Comparison with Nifty Midcap 100 & Nifty Next 50.
In fact, after this post, I am no longer interested in a mid cap and small cap index. I think based on the present data (limited as it may be), as
Nifty Next 50 is an excellent midcap index fund.
I have no problems with having a good enough exposure to mid-caps in a long term portfolio, but my argument is, why not get that from Nifty Next 50 itself? This way, you can have only index funds in your portfolio. Either Nifty 50 + Nifty Next 50 or Sensex + Nifty Next 50. Of course, you can have 60% of NN50 if you prefer to take on more volatility.
I am trying to get into the habit of posting short videos every day and yesterday I discussed why Sensex and Nifty indices are pretty much the same.
My index investing posts seems to have contributed to a fear of missing out in the minds of active investors. Good! In the next post, we will discuss how o choose active funds in this age of indexing. For young investors and fans of passive investing, the message is clear: you only need two kinds of funds: a large cap fund for stability and a high-quality mid cap fund (like the NN50) for performance. You do not need small caps or micro caps or any other actively managed diversified equity funds.
Update: Should I now shift active mutual funds to index funds? A step by step guide
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