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Choosing funds on the basis of market capitalisation

Mutual funds are collective investment schemes that pool money from a large number of investors and invest it according to their mandate. Equity funds are those that invest in shares of companies that run business for a profit. These companies come in many sizes. There are the huge companies which are worth lakhs of crores and then there are the small ones worth a hundred crore or less. The common terminology that refers to the company’s size is “market capitalization” or “market cap” in short.

Consequently, mutual fund schemes too come in different configurations depending on where they invest the money. There are schemes that focus on large companies, some on medium sized companies and some on small companies. There are of course some which invest across the market cap range.

About market capitalization

Market capitalisation is nothing but a multiplication of the total shares issued by a company by its current market price. For instance, if XYZ Ltd has issued a total of 1 crore equity shares and the current market price is Rs 100 per share, its market capitalization is Rs 100 crore (1 crore equity shares multiplied by Rs 100 per share). As the share price of a company depends on its earnings potential, assets held and goodwill in the market among other factors, market capitalization too is influenced by these factors.

Usually, companies with larger market capitalization are known to be less risky and their stock prices less volatile. This is primarily because such companies have a large amount of stock available, and hence, more investors. Thus, even if there are large lots of stocks traded, these trades don’t impact the stock price dramatically. Against this, mid and small companies that have very little equity in the markets can experience dramatic rise and fall in their stock prices in case of large trades.

Large cap stocks are typically more researched and hence more widely held than the smaller ones. They hence have a better price discovery with very little scope for surprise elements (profitability, debt burden, market share, etc.) to impact the share price suddenly. But medium and smaller sized companies are not that well researched or widely held. This makes them more vulnerable to sharp movements in price. This is where mutual funds play a crucial role as they make investment decisions based on solid research and analysis thereby reducing the risk of investing in these companies.

Large, mid and small cap funds

Though stocks and hence funds are identified with a market capitalization range, namely large, medium and small, there is no fixed definition for this classification. Classification of companies in terms of size is subjective. Some may classify based on the absolute valuation number of the companies. For example, a company with a market capitalization above Rs.20,000 crore as a large cap, between Rs.10,000 crore and Rs.20,000 crore as mid cap and smaller than those as small cap. Others could follow a relative classification system like bracketing the top 100 companies as large cap, the next hundred as mid cap and the others as small cap.

Equity funds usually specify which segment of the market capitalization range that the scheme would focus on. Typically it could be large cap, mid cap, small cap or multicap which would invest in more than one capitalization. Each of these categories comes with its own characteristics with regard to risk and return. While large cap funds would exhibit more stability with regard to price movements and returns generation, the price and return volatility go up as one moves down the size classification. Medium sized companies experience high price volatility and small companies even more. The investment risk is therefore higher in medium and small sized companies than the large ones though they have the potential to generate higher returns over the long term than the large ones.

Selecting among different market capitalizations

Mutual funds offer specific schemes that invest in large cap stocks, mid cap stocks and small cap stocks. They also offer ‘diversified’ schemes that invest in stocks across market capitalizations. Performance of these funds is benchmarked against the respective indices, i.e. diversified funds are benchmarked against broad stock market indices (BSE-500 , CNX 500, etc.); mid cap funds are benchmarked against mid cap indices (BSE Mid Cap index, CNX Mid-Cap index, etc.) while small cap funds are benchmarked against small cap indices (BSE Small Cap index, CNX Small Cap Index, etc.).

Given that large companies are well researched, widely held and return a relatively stable performance, large cap funds should form the bulk of an investor’s portfolio. They should form the core which would provide a relatively stable source of returns with lower volatility. Mid and small cap funds should also form a minor portion of the portfolio as they are capable of generating superior returns though with a higher risk.

To conclude, selecting stocks requires knowledge of broad markets, sectors and specific stocks. There are a number of parameters that need to be used and assessed to make the right selection of stocks. With mutual funds, you get access to professional fund managers who have deep knowledge of the markets. Market capitalization is just one of the many parameters they use to make their stock selection. Clearly, investing through mutual funds is most preferable.

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Mutual fund investments are subject to market risks, read all scheme related documents carefully.