There has been a plethora of studies on testing of market efficiency that have established that it is very difficult for professional managers to beat the market index. The ability to outperform is greater as one moves down the market capitalisation spectrum. The information flow on companies not followed by many analysts would be less, leading to pricing inefficiencies. Such neglected stocks are "discovered" by the analysts.The liquidity levels generally go down as one goes lower down the spectrum of capitalisation. Institutional investors are not willing to trade liquidity for returns. The transaction cost on stocks with wide bid-offer spreads is higher, discouraging institutional investors from picking up these stocks.
Mid-cap offers the advantage of better liquidity than the small stock companies as they comprise better researched companies. In the USA, the mid-cap segment was discovered only in 1991, when Standard & Poor though it fit to create an index that would capture the excess returns forportfolio managers not captured by S&P 500, an index of large cap blue chip stocks. The pioneering work of Fama and French in "The Cross - Section of Expected Returns", in the Journal of Finance, June 1992 showed that size (measured by market cap) and book to market value accounted for differences in return for the different segments of the market. The most widely used benchmarks for the mid-cap segment in USA are the Russell Midcap 800, the S&P MidCap 400, and the Wilshire 750(numbers indicating the number of companies). It is now widely accepted that $200 million to $5billion spans the mid-cap. The average size of the S&P Midcap 400 is $1.6 billion which is one-sixth of the $10.1 billion average for S&P 500.
The initial years of the introduction of the S&P 400 saw roughly a turnover of 16 companies per year. While only 4 per cent of the names changed each year, nearly 10 per cent of the market capitalisation was removed annually. Many companies deleted from S&P 400 were added to S&P 500 in the earlynineties. There was also a shift in the sectoral composition of the index, with the inclusion of companies from the emerging sectors. As our market is undergoing a major changes, it has been difficult to precisely define the mid-cap segment. With the listing of banks and public sector firms, the market size has expanded and is likely to expand further with the accentuation of the privatisation process. Hence we would witness the Migration Effect that has been experienced by all developing markets in their evolutionary phase. Some of the existing large caps will migrate to the mid-cap to accommodate the newly listed very large cap firms. Some of the large cap companies like Century Textiles, Siemens, and Madras Cements have lost investor fancy, as reflected in their declining market cap. Such stocks have migrated from large-cap to the mid-cap segment. The top 1000 companies by market capitalisation, in the Bombay Stock Exchange account for 96.45 per cent of total market cap. The Sensex contains the largecompanies (except for Arvind Mills) having a market capitalisation of Rs 1000 crore and over, while Nifty has both large cap and mid cap companies. The Crisil 500 has large, mid-cap and small-cap companies, while the MIDCAP 200 Equity Index is a broad based mid cap index. Definitions of size would undergo changes with the changes in the market capitalisation of individual companies because of mergers, increase in issued capital, debt conversions and increase in the price of a stock.
This has implications for portfolio benchmarking. Funds with large exposure to large cap stock will have to benchmark their portfolio performance to a large cap index of liquid stocks and those with high exposure to the midcap segment will have to benchmark against a broad-based mid-cap index like the Crisil Midcap 200 Index. Mutual funds with considerably exposure to stocks that have migrated from the large cap segment to the mid cap segment would be well advised not to use a large cap index like Sensex for benchmarking. It isheartening that the more transparency on the part of the mutual funds.Sebi should also asks mutual funds to indicate the benchmark they would beadopting for the purpose of performance evaluation of their funds andexplain the basis of choosing the benchmark.
There has also been a sectoral migration in the mid-cap segment. The software sector has grown in importance in 1997, resulting in the migration of companies like Infosys, NIIT, and Wipro from the mid cap to the large cap segment. The automobile sector has also shown growth in size. On the flip side, cement, paper, fertilizer, steel and finance sectors have experienced substantial decline in marketcap, reflecting the loss of investor interest in these industries. Companies like India Cements, Nagarjuna Fertilizer, Ballarpur Industries, and Jindal Strips have experienced huge erosion in their market cap since 1995-96. These changes resulting in the fading of commodity based industries and the rise of service and utility industry is part of the structuraltransformation of economies in the path of development.
Depending on the expected results of different segments of the market, a fund manager can have a high exposure in the segment that is expected to perform well. The choice of the benchmark for evaluation should mirror his sectoral exposures.
(The author is a consultant to Crisil Research and Information Services, Mumbai)
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
