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Why Multicap Funds may be the best option for less experienced investors

Feb 16, 2017 by Dwaipayan Bose |  94 Downloaded |  3897 Viewed
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Mutual funds offer a multiple options for a large variety of investment needs. However, since there are a large number of schemes with similar investment mandates, fund selection can become very confusing for less experienced investors. Personal finance experts say that, investors should select funds based on their risk appetites. Making investment decisions based on risk tolerance is easier said than done, especially in equity investing. When you have decided to invest in equity, it means that you have a high risk appetite. But how will you decide whether to invest in large cap or midcap? Is there a defined maximum loss percentage above which one can invest in small or midcap funds and below which one should invest in large cap? The answer is no.

Investing in large cap versus small / midcap funds are often based on very subjective considerations. Many a time investment decisions are based on the flavours of the season. In bull markets small and midcap funds are popular investment choices. In volatile markets, balanced funds are favoured by investors and financial advisors. After deep corrections, valuations of large cap stocks appear cheap and large cap funds look attractive for investments. Market conditions will change from year to year but your long term investment goal will remain the same; hence it is unwise to make long term investment decisions based on current market conditions.

Midcap funds are expected to outperform large cap funds in bull markets and underperform in bear markets. However, this is not always true. Large cap funds did outperform midcap funds in bear market years of 2008 and 2011, but underperformed in 2015 (another bear market year). In 2013, which was essentially a flat market year, midcap funds underperformed versus large cap funds. In some market rallies, the performance differential between mid-cap funds and large cap funds was huge (e.g. 2009, 2012 and 2014). However, in other bull market years, though midcap outperformed the performance difference was not that big (e.g. 2007, 2010 and 2016). The point I am trying to make is that, we cannot expect funds to behave in a certain pattern in a given market condition in the future. If you are confused between large cap and midcap funds, then Multi-cap funds may be right long term investment solutions for you.

What are Multi-cap Funds?

Multi-cap funds do not have restrained investment mandates. They are both sector and market cap agnostic; and are truly diversified equity funds in that sense. Multi-cap funds are also referred to as flexicap funds, diversified funds etc. Usually, 50 to 75% of the portfolios of Multi-cap funds comprise of large cap stocks, while the balance 25 – 50% portion comprise of small and midcap stocks. Multi-cap funds are one of the most popular mutual fund product categories in terms of Assets under Management (AUM) and all Asset Management Companies (AMCs) have one or more Multi-cap funds in their product portfolio. These funds are suitable for a wide variety of long term investment objectives like retirement planning, children’s education, marriage etc.

Benefits of Multi-cap Funds

The flexible investment mandate enables fund managers of Multi-cap funds capitalize on a broader set of value and growth opportunities in the market.

  • In equity markets we see liquidity flowing to different sectors and market cap segments, based on relative valuations. Large cap stocks are usually more richly valued compared to midcap stocks. In bull market rallies, the valuations of large cap stocks may seem stretched and cheaper midcap stocks become attractively valued. That is why, we usually see midcap stocks outperforming large cap in bull markets. However, when risk sentiments deteriorate, midcap stocks are seen to be more risky and they correct more than large cap stocks. In the bear market of 2008 and 2011, we saw midcap stocks falling more than large cap stocks. In India, Foreign Institutional Investor (FII) activity also plays a huge role in equity prices. When global risk sentiments worsen, FIIs shift from equity to safer assets like US Treasury Bonds. Since FIIs invest mostly in large cap stocks, FII outflow can impact large cap stocks more than midcap stocks, as we saw in 2015. The point is that, different segments of the market outperform each other in different market cycles.Multi-cap funds have both large cap and midcap companies in their portfolio. Therefore have the potential to deliver good performance on a more consistent basis in the long term.

  • The chart below shows the performance of large cap, midcap and multi-cap funds over the last 10 years.

    Mutual Funds - Performance of large cap, mid cap and multi cap funds over the last 10 years

    Source: Morningstar


    You can see that, multi-cap funds outperformed large cap funds in bull market years and yet in bear market years, its performance was similar to large cap funds. In fact, in 2015, when the Nifty fell around 20%, multi-cap funds outperformed large cap funds. Multi-cap fund managers do not restrictive investment mandates and can shift allocations between large cap and midcap segments depending on the situation.

  • Diversified funds have the potential and tend to outperform large cap funds in the long term. The diversified funds have 25 – 50% of their portfolio invested in small and midcap companies. Small and midcap companies have the potential to give higher returns than the large cap companies, because of their earnings growth potential due to smaller size and valuation arbitrage. Let me explain, what valuation arbitrage is. Small and midcap stocks tend to be under-researched. Since less is known about these companies, the market gives these stocks lower valuations. A good fund manager can identify good small and midcap stocks, which are trading at considerable discount to their fair price. These stocks can give very high returns in bull markets, when market realizes their fair value. As a result, diversified funds tend to outperform purely large cap funds in bull market conditions.

  • While in bull markets small and midcap stocks rally, in bear markets they are perceived to be more risky, they suffer sharp declines. The free float of many small and midcap stocks is quite small in our market. If the free float percentage of a stock is small, an investor may not be able to find buyers for it in the market. Consequently, small and midcap funds face liquidity constraints when redemption pressure increases in bear markets. As a result, the fund managers are forced to sell stocks, which they do not want to sell to meet redemption requests. This may have a negative impact on the investors who still remain invested in the scheme. Diversified funds on the other hand do not face liquidity problems in bear market, since large cap stocks comprise a substantial portion of their portfolio.

  • The small free float of small and midcap stocks becomes an issue, when the AUM of a small / midcap fund grows beyond a certain size. The fund manager simply has no choice but to invest in large cap stocks. Some small and midcap funds restrict lump sum investments, while others over a period of time become multi-cap funds.

  • Financial advisors often advise investors a mix of large cap and midcap funds to get the best results over a long investment timeframe. The percentage mix depends on the subjectivity of the investor and advisor. A multi-cap fund gives investors the combined benefits of both large and midcap funds with the convenience of having to monitor and track only one fund (instead of two).

Conclusion

In this article, we have discussed that the multi-cap funds which invests across market capitalizations and sectors are ideal for retail investors. As such these funds should form the core of an investor’s portfolio. What percentage of your equity portfolio should be invested in multi-cap funds? 100% of your portfolio can be invested in these funds. As you gain more experience in investing, you can add large cap or small/midcap or more multi-cap funds to your portfolio. Investors should review their investment portfolio and discuss with their financial advisors, if they should include multi-cap funds in their portfolios.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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