Invest in a multi-cap fund for high allocation to mid- and small-cap stocks

Beware that these funds will be more volatile than other diversified equity categories, barring mid-cap and small-cap funds

The new fund offers (NFOs) of multi-cap funds from HDFC Mutual Fund and Axis Mutual Fund are on currently. While the former’s NFO will close on December 7, the latter’s will end on December 10.

The Securities and Exchange Board of India (Sebi) had altered the characteristics of multi-cap funds in September 2020 to make them more true-to-label. These funds must have a minimum 25 per cent allocation each to large-cap, mid-cap, and small-cap stocks, while the balance 25 per cent can be invested dynamically. At present, this is a small category whose average asset under management (AUM) stood at Rs 32,348.7 crore at the end of October.

Exposure across market caps

Multi-cap funds give investors consistent exposure across market cap segments. “Many retail investors are keen to invest in the mid- and the small-cap segments. But they don't have the patience to remain invested and instead try to time the markets. As a result, they miss out on the gains from these categories,” says Anupam Tiwari, equity fund manager, Axis Mutual Fund.

Combining all three market-cap segments in one fund also makes it less volatile compared to standalone mid-cap or small-cap funds.

Some exposure to the mid- and small-cap categories is necessary for retail investors. “Over the past 10 years, we had policy paralysis, taper tantrum, demonetisation, introduction of GST, the NBFC (non-banking financial companies) crisis, Covid, slowdown of 2018-19, and so on. Despite these problems, the mid- and small categories have given decent returns. The market is widening and new companies are emerging,” says Tiwari. The chemicals sector, for instance, has emerged in India over the past 10 years. Retail investors need to be invested in mid- and small-cap segments to capture the growth in smaller, emerging companies. “The movement across market-cap segments is also accompanied by PE (price-to-earnings ratio) rerating, which can result in high returns for investors,” says Gautam Kalia, head–investment solutions, Sharekhan by BNP Paribas.

However, capturing the growth in mid- and small-cap stocks is not easy. “Historically, it has been challenging for small-cap companies to become mid-cap companies, and for the latter to become large-cap companies. There have been many fatalities in the process,” says Tiwari. Investors need fund managers who can pick the right stocks that have the ability to grow sustainably and create wealth over the long term.

Investing across market caps is also important because different market segments outperform in different years (see table). Generally, large caps tend to be more resilient in poor market conditions, while mid and small caps tend to outperform in a bullish environment.

Volatile category

A 25 per cent exposure to small-cap stocks could make multi-cap funds volatile. “If you look at the top 500 stocks on the NSE or the BSE, large caps have a 75-80 per cent weight by market cap, mid caps contribute 15-20 per cent, and small caps account for 5-10 per cent. So, a 25 per cent allocation to small caps in multi-cap funds is high,” says Arun Kumar, head of research, Fundsindia.com. The small-cap segment performs in phases. After outperforming for several years, it underperformed in 2018 and 2019.

In the future, if a multi-cap fund becomes very large, then finding enough quality small-cap stocks to fill the 25 per cent allocation requirement could prove difficult.

More rigid than flexi-cap funds

A flexi-cap fund also invests across market segments, but there the fund manager does not need to maintain a rigid 25 per cent allocation to each market-cap segment. “A flexi-cap fund’s manager can allocate according to his view on the segment he expects will do well. If the mid- and small-cap segments have become overbought, and the fund manager believes it is time to get defensive, he can allocate more to large caps, and vice-a-versa,” says Kalia. The manager of a multi-cap fund doesn’t have such flexibility.

Investors looking for lower exposure to mid- and small-cap stocks, and who want to hand over the allocation decision on markets-cap segments to the fund manager, may opt for flexi-cap funds.

Who should opt for multi-cap funds?

Investors who want very few funds in their portfolios, and are keen on a constantly high exposure to mid- and small-cap stocks may opt for multi-cap funds. Such investors must have a high risk appetite and should be able to tolerate the higher volatility in these funds (compared to categories like large-cap, large and midcap, and flexi-cap funds). They must have an investment horizon of seven years or more to invest in these funds.

Before investing in the NFO of these funds, investors should check out the track record of the fund manager in managing funds across market segments.

Alternative approach

Investors who don't want to combine funds may opt for separate large-, mid- and small-cap funds. Doing so will give them the freedom to choose the best fund managers across fund houses for each of these categories. “Alternatively, you can build a portfolio by allocating 20 per cent to each of these five investment styles: Value, quality, blended (growth at reasonable price), mid and small cap, and global. You may use flexi-cap funds for each of these categories, barring mid and small cap,” says Kumar.