Is it a Sensible Strategy to Invest in Both, Flexi-cap Fund and Multi-cap Fund?

February 11, 2022 Mutual Fund

After a stellar run in 2021, sharp volatility is plaguing the Indian equity market since the past few weeks due to the recent concerns about the looming threat of omicron variant, and the US Federal Reverse’s announcement of tightening the monetary policy, that will be followed by RBI with hike in interest rates to control the inflation. Depending on RBI’s action and stance against monetary policy changes, the domestic equity market may experience intensified volatility in the near term.

Given the current market conditions, it could be the right time for investors to consider diversifying their equity portfolio across market capitalization and sectors to achieve significant returns over various market cycles. In order to ride out market volatility, investors must devise an effective strategy to have an asset mix that includes large-cap stocks for a better margin of safety and stability, as well as mid-cap and small-cap stocks for higher growth potential. Such a strategy will help counter the volatility and boost the portfolio returns.

Given that, various schemes offer diversification with asset mix across market cap within the equity market. Multi-cap Funds and Flexi-cap Funds are the most popular equity mutual fund categories that invest across market caps. In the long run, a portfolio with a mix of market caps allows for optimal wealth creation, mitigates the market risk, and offers better risk-adjusted returns.

You are probably wondering what is the difference between the two types of equity mutual funds that invest across market capitalization and which one will be most beneficial for you?

Well, to find out if investing in Multi-cap funds or Flexi-cap funds will boost your portfolio returns, we need to first understand how the two categories differ in terms of portfolio characteristics and risk-reward ratios.

What are Multi-cap funds?

Multi-cap funds are equity-oriented mutual funds that can invest in stocks diversified across market capitalization, i.e., large-cap, mid-cap, and small-cap stocks. However, in September 2020, SEBI introduced new regulations for asset allocation of Multi-cap funds.

Multi-cap funds are mandate to invest at least 75% of their total assets in equities, with at least 25% exposure each in large-cap, mid-cap, and small-cap stocks. Do note that, regardless of market conditions, multi-cap funds must maintain a minimum exposure of 25% in each market cap.

• A minimum of 25% of the total assets in large-cap stocks
• A minimum of 25% of the total assets in mid-cap stocks
• A minimum of 25% of the total assets in small-cap stocks

The remaining 25% of the total assets are invested in debt and money market instruments.

Multi-cap funds provide investors with a superior risk-adjusted return by combining the stability of large-caps with the high-return potential of mid-cap and small-cap stocks. The fund manager’s ability to shift asset allocation to a certain market capitalisation segment in a market phase is limited as each market cap must maintain a minimum of 25%.

What are Flexi-cap Funds?

SEBI established Flexi-cap funds, a new type of equity-oriented mutual funds, in November 2020, shortly after making revisions to the Multi-cap segment. Flexi-cap Funds are defined as funds that invest at least 65% of their assets in equities and equity-related products, with a dynamic allocation between large-cap, mid-cap, and small-cap stocks.

Unlike Multi-cap funds, here the fund manager has flexibility to invest wherever value and opportunities are available without any restriction on market cap. Flexi-cap funds do not have a minimum limit as to how much proportion it should hold to a respective market capitalization segment. Investors can take positions based on risk-return opportunities thanks to the scheme’s variable asset allocation.

Flexi Cap Funds are less volatile than pure mid-cap and small-cap funds. They provide investors with a low-risk way to participate in emerging markets’ mid-cap and small-cap segments. Flexi-cap funds can drop their mid-cap and small-cap allocations to zero, depending on market phases to keep market volatility at bay.

Before investing in a Multi-cap or Flexi-cap fund, carefully evaluate the portfolio characteristics of the respective schemes to see how well they have diversified their portfolios and managed the risks the investments schemes pose.

These funds will be actively managed by the fund managers, who may boost the allocation to mid-cap and small-cap segments if they see an investing opportunity. Multi-cap funds have a market cap limit of at least 25% in each category, whereas Flexi-cap funds have no such market cap limit. As a result, both funds are high-risk, high-reward investments.

In case, the allocation is not appropriately diversified and the quality of its holdings is poor, the schemes could expose your investment to high risk. However, if any investment decision goes awry, it may lead to heavy losses.

You may also check the past performance (across time frames and market phases like bull, bear, and consolidation) and the level of risk it has exposed its investors to. Notably, past returns are only to provide you with a better understanding of the fund and not an indication of future returns.

How do Multi-cap funds and Flexi-cap funds perform in various market phases?

In 2021, even though Flexi-cap funds sustained the market volatility effectively, Multi-cap Funds outperformed Flexi-cap Funds by a noticeable margin. According to the experts, this is majorly attributed to the run-up in small-cap and mid-cap stocks last year. A broad-based market rally took the stocks of smaller companies that were beaten down amid the pandemic to new highs. The mid-cap and small-cap stocks also performed well in comparison to their large-cap counterparts.

Due to a market cap constraint of at least 25% in each segment, Multi-cap funds have a higher exposure to mid-cap and small-cap equities. The exceptional growth in the values of smaller companies benefited the mid and small-cap categories, which worked in favour of Multi-cap funds.

Table 1: Multi-cap and Flexi-cap fund performance across market cycle returns

Data as on February 10, 2022
(Source: ACE MF)  

Given that, if there is an all-round rally across market capitalizations during a bull market trend, Multi-cap funds tend to perform better. On the other hand, during a bear market, a Multi-cap Fund may be more vulnerable than a Flexi-cap Fund. It must maintain a well-balanced portfolio with a large-cap allocation, which may provide some stability, to survive the tides of volatility.

Flexi-cap funds hold a quality portfolio of smaller companies, particularly when mid-caps and small-caps are expected to outperform the large-caps in a bull market phase, to reward the investors with optimal returns. This flexibility aids fund managers of a Flexi-cap Fund to generate alpha by astutely identifying the opportunities and risks across the market cap spectrum.

Flexi-cap funds, by skewing the equity portfolio predominantly to large-caps, may limit downside risk better than a Multi-cap Fund in bear market conditions, when mid-cap and small-cap stocks are highly volatile. It could simply reduce the allocation to mid-caps and small-caps as there is no market cap restriction.

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Which one will be a suitable fit for your portfolio?

In order to decide whether to invest in a Multi-cap fund or a Flexi-cap fund, assess and review your financial goals, risk profile, and investment horizon. You should avoid investing in either category based on its short-term performance as a result of a market rally, and instead evaluate the schemes’ quantitative and qualitative features.

Considering that both Multi-cap and Flexi-cap Funds have a significant allocation to equities in the mid-cap and small-cap segments, both of which are highly risky, these categories are best suited to investors with a high-risk tolerance and a 5-7 year investment horizon.

Both Multi-cap and Flexi-cap schemes have their distinctive traits and its share of benefits and risks, the performance of the two categories can differ in different market phases. As a result, regardless of which category you choose, make sure you invest in worthy schemes after evaluating their performance and ensuring that they are compatible with your risk profile, investment horizon, and objectives.

Although the equities market favoured Multi cap funds last year, during the upcoming volatile period, which is expected due to the headwinds in play, Flexi cap funds with a higher contribution of large-cap stocks may perform better. The expectations of tighter monetary or fiscal policy across the globe can cast a shadow on equities markets. In case of such downturns, the mid & small caps are vulnerable to market/s movements; they exhibit high volatility and may have more significant drawdowns.

In such a scenario, Flexi-cap funds have the advantage of reducing their mid-cap / small-cap exposure to zero and can allocate their assets to the large-caps. Multi-cap funds, on the other hand have to maintain a minimum of 25% exposure in midcap and small-cap stocks, which may increase the downside risk and volatility.

Thus, in these unpredictable market conditions, it makes sense for investors to invest in Flexi-cap funds to generate decent returns across market caps. Flexi-cap funds are suitable for investors looking to invest in a large-cap oriented fund along with tactical allocation to mid-cap and small-cap stocks for potential growth in their portfolio.

Well, here are some of the best performing Flexi-cap funds to invest in 2022:

• Parag Parikh Flexi-cap Fund
• Canara Robeco Flexi-cap Fund
• UTI Flexi-cap Fund
• PGIM India Flexi-cap Fund

Note that, you must evaluate the scheme’s performance on various qualitative and quantitative parameters. Select a scheme that is in line to your risk tolerance and investment goals.

To conclude…

During volatile market periods, investors should use the dynamic asset allocation (DAA) approach. It assists in reducing the downside and mitigating volatility at the portfolio level, as well as taking advantage of opportunities provided by varying market caps during various market cycles. It is prudent to choose a fund with an investment approach that is flexible to adapt to ever-changing market scenarios.

In recent months, a number of fund houses have launched new Multi-cap and Flexi-cap Funds with these qualities. We have seen Flexi-cap and Multi-cap mutual funds run as separate vehicles, the two sets of funds have taken distinct shapes in this time frame and investors may consider the one as per their suitability.

Therefore, when choosing mutual funds for your investment portfolio, make sure the fund house has a significant performance record and follows robust investment processes with adequate risk management systems. Furthermore, to limit the impact of volatility and benefit from the power of compounding, you might invest in the scheme via Systematic Investment Plan (SIP) option.

This article first appeared on PersonalFN here