Mid Caps, Small Caps And The Retail Investor’s Portfolio

Most investors would wish to include mid and small cap equity in their portfolios. But the right way to approach mid and small cap investing is still not properly understood. A number of questions need to be answered to gain a holistic understanding of the subject. Are mid and small caps a necessity in an equity portfolio? Are the pros of including them worth the cons? What is the right way to include mid and small cap equity, if warranted? What must investors keep in mind when including mid and small cap equity? The answers in today's post.

Are The Pros Of Mid And Small Caps Worth The Cons?

The case for mid and small caps is an easy one to make, at least in theory. Mid and small cap stocks represent relatively undiscovered companies. They therefore offer investors a better chance to beat the market return. The mid and small cap stock universe in India (150 and 250 stocks respectively) is broader than the large cap stock universe (100 stocks). This means investors have a wider variety of choice within mid and small caps.

But mid and small caps are significantly riskier compared to large caps. So the higher expected return they offer comes with heightened volatility. They are also a lot more illiquid compared to large caps. This means that investors who want to get out when mid and small caps do badly would have a hard time doing so. All of these factors adversely impact the investment experience of investors in these segments of the equity market. This lowers the chances of investors sticking to mid and small caps over long periods of time. This makes it clear that the cons of investing in these segments outweigh the pros in most cases.

Are Equity Portfolios Ineffective Without Mid And Small Caps?

Before answering this question, we must first understand the core objective of portfolio construction. We construct portfolios to give ourselves a reasonable chance of matching inflation on a post tax basis over the long term. This would give us a reasonable chance of achieving our financial goals. So our portfolios as a whole must be aligned towards matching inflation post tax over the long term.

Long term post tax returns from large cap equity are more than sufficient to meet this requirement. This means that equity portfolios would remain completely effective even without the inclusion of mid and small cap equity. But investor preference also has a role to play in portfolio construction. Investors who desire a higher risk adjusted return on their portfolios may consider adding mid and small cap equity. Upto 50% of the equity portfolio can go into these segments.

What Doesn't Work?

A clear approach to mid and small cap investing is essential to effective portfolio construction. Mid and small cap equity can seemingly be included in a number of ways. Investors can directly pick stocks in these segments. Holding actively managed funds or curated baskets of such stocks is another option. And there is also the option of holding mid and small cap index funds. Let me start by highlighting what won't work.

Directly picking stocks represents the most risky option among the ones available. Picking a particular stock represents conviction that the stock will do well over our intended investment horizon. This means that we would essentially be taking a bet on the future. There is no way to predict the future reliably, consistently and accurately. So investors would be better off not going down this route.

Holding actively managed mid and small cap funds may seem to represent a better option. The same can be said for curated baskets of mid and small cap stocks. But a look at the data would reveal something entirely different. The SPIVA India Mid Year 2025 report shows that 82% of actively managed mid and small cap funds underperformed their benchmarks over the preceding 10 year period. This is laid out in the graphic below which is taken from the report.

The same is true for curated stock baskets. Most of them would underperform the benchmark. Any outperformance from active funds or stock baskets is likely to be lost to costs and taxes. And it is near impossible to identify the outperformers in advance. So these too don't represent viable options for investors.

That leaves passive options for mid and small caps. Nifty Midcap 150 and Nifty Smallcap 250 index funds are one option. But these may prove to be too volatile for most investors. A Nifty 500 index fund is a relatively more viable option. It offers exposure to the Nifty 100, Midcap 150 and Smallcap 250 indices. So it virtually covers the entirety of the Indian stock market.

But very few fund houses in India currently offer Nifty 500 index funds. And only one such offering is a viable fit for investor portfolios. So investors would be better off waiting until more fund houses offer Nifty 500 index funds. More on this in my earlier article Defensive Investing Decoded - III : Constructing Defensive Portfolios.

So... What Works?

Investors looking to go beyond large cap equity can consider a Nifty Next 50 index fund. A Nifty Next 50 index fund is an effective proxy for mid and small cap equity. Long term rolling returns and standard deviation of the Nifty Next 50 index are comparable to that of the Nifty Midcap 150 index. Upto 50% of the equity component for a long term goal may be allocated to Nifty Next 50.

A Nifty Next 50 index fund would be available with most major fund houses at an expense ratio of 0.3% per annum. This would be a fair expense ratio to pay for a Nifty Next 50 index fund. A portfolio with a 50-50 blend between Nifty 50 and Nifty Next 50 costs around 0.25%. But investors must acknowledge that including a Nifty Next 50 component in the portfolio would heighten portfolio risk and volatility.

What Investors Must Keep In Mind

Equity portfolios must be geared towards earning a reasonable long term post tax return while optimising portfolio risk. Most investors view mid and small cap equity as means to earn exponential returns. But that does not always happen. And to be honest this is not an objective worth aiming for. Earning a long term return that enables us to achieve our goals is sufficient. Long term returns offered by mid and small caps may not always justify the risks involved. So investors must put a lot of thought into the decision to include mid and small cap equity. If they decide to include mid and small caps, they must do so responsibly.