Are multi-cap funds answer to your investment needs?

Investment in equity funds gives you a wide choice to select from. You can select large cap funds with lower risk and relatively stable returns. Alternatively you can opt for mid-cap funds or small cap funds for generating alpha or excess returns with higher risk. One of the basic rules in financial planning is to focus your equity component on large cap diversified funds so that returns are more predicable in the long run.

The balance is allocated to mid-caps. But then fund selection is still a challenge for the investor. One option is to opt for multi-cap funds.

The multi-cap funds are a mixed type of mutual funds that invest in large cap and mid-cap funds in varying proportions. The advantage is that you don’t have to worry about fund selection in large caps and mid-caps separately. Based on your risk capacity and asset mix required, you just opt for a good multi-cap fund.

The fund manager takes care of the allocation between large caps and mid-caps and also takes care of the stock selection.

How do multi-cap funds operate?

These funds create a hybrid portfolio consisting of large cap, mid-cap and small cap stocks. In fact, such funds begin with an allocation towards each category and then go about stock picking within each category.

Multi-cap funds may have underperformed in the last one year since mid-caps and small caps grossly underperformed large caps in the last one year. However, over a longer time frame of 5-10 years, the cycles tend to get evened out and multi-cap funds do better.

Before opting for multi-caps, know the choices in front of you.

As a mutual fund investor leveraging on funds to meet your long term goals, you have two distinct choices in front of you.

n Firstly, you can opt to allocate funds to large caps funds, mid-caps funds and small cap funds and manage these funds separately. Here you will have to do your research and select the individual funds in each category accordingly.

n The other alternative is to invest in multi-cap funds wherein the fund manager automatically creates a portfolio of large cap, mid-cap and small cap stocks. You just buy the multi-cap fund and leave it to the fund manager to make the allocation.

How should you make a choice?

There certainly is merit in creating a multi-cap portfolio of large caps, mid-caps and small caps. Mid-caps and small caps operate on smaller bases and can outperform easily. Over the longer period, the multi-cap funds generate higher alpha.

Should you opt for creating your own mix of large cap, mid-cap and small cap funds or should you directly opt for a multi-cap fund and save yourself the hassles? You must consider four variables here…

n In terms of simplicity, the multi-cap fund clearly scores as it makes the job much easier. You have no worries about identifying large cap funds, mid-cap funds and small cap funds and then talking to your advisor and deciding on allocations. Multi-cap fund is an auto allocation fund and creates a mixed-size portfolio for you. After all, there are too many analysts tracking Infosys and RIL with only so much returns in them.

n How do they compare on diversification. To be fair, both approaches help you to diversify. Apart from spreading your money across sectors and themes, you also spread your investments across size and capitalization. Of course, in case of multi-cap funds it is a lot more passive whereas in the other case, you have to do the allocation to funds.

n Let us now look at flexibility and that is where your allocation scores over multi-cap funds. Allocating funds on your own gives more flexibility to customise your portfolio according to your specific needs. The multi-cap fund manager will adopt a median approach to investing in multi-cap stocks. The multi-cap fund is a one-size-fits-all approach and is not flexible enough to change with your changing risk profile.

n Don’t forget that stock selection and fund management are specialised jobs.

Some fund managers have been very successful in managing large cap funds while other fund managers are adept at managing mid-cap funds. The market is still not sure if there is something called a multi-cap DNA in fund managers. The table below captures how mid-cap volatility has impacted the medium term returns of multi-cap funds.

The performance of multi-cap funds is extremely vulnerable to the performance of mid-caps, which is demonstrated in the superior returns over five years.

Investors may be better off putting in a little more effort and combining large cap and mid-cap funds separately. That gives them better control over allocation.

Conclusion is that multi-cap funds do offer simplicity and are ideal when you cannot spend too much time in active monitoring. It also provides inbuilt diversification. But, there are challenges.

Multi-cap funds cannot be customised in a granular fashion and ignore the aspect of specialisation and DNA. The moral of the story is that if you can manage allocation then do it yourself. Else, the comfort of multi-cap funds is always available to you!

(The writer is Chief Revenue Officer - Angel Broking Ltd)