Late last year, market regulator SEBI issued guidelines to make multi-cap funds more true-to-label by enforcing minimum exposure to large, mid and small-cap stocks. While a few AMCs (asset management companies) adjusted their multi-cap funds as per the mandate, several converted their existing multi-cap funds to flexi-cap schemes so that they could continue with their large cap-heavy portfolio allocations. As of end-April 2021, the market had around 25 flexi-cap funds with Rs 1,59,480 crores of AUM, and 12 multi-cap funds with Rs 19,846 crore in AUM.
New fund offers in both, multi and flexi-cap schemes, have continued to hit the market as AMCs try to ensure their presence in both categories. With both fund categories designed to invest across large, mid and small-cap funds, differentiating between multi and flexi-cap schemes can seem like a confusing task for retail investors.
Is it only a difference of the degree to which each invests across market capitalization? How large can this difference be? And what can be the possible impact on risk and return?
The capitalisation spectrum
The mid and small-cap segments in the capital market offer a larger universe of less-discovered stocks to choose from. This means two things: 1) fund managers have greater scope to use bottom-up strategies to identify potential winners and, 2) these segments of stocks can face liquidity issues as they may not be frequently traded.
Another important aspect is the ‘beta’ of mid and small-caps. Mid and small-caps can be disproportionately impacted by market movements, which means they are usually more volatile than large cap stocks. Because of these characteristics, investing in mid and small caps is considered a relatively high risk-high reward venture, requiring a long-term mind set.
The difference between multi-cap and flexi-cap funds
The key difference between multi and flexi-cap funds is of the degree to which they are exposed to mid and small-caps. More importantly, this difference can become quite large depending on market conditions. Flexi-cap funds can dial down their exposure to mid or small caps right down to zero, if the fund manager deems it necessary; however, in the case of multi-cap funds, this exposure can never go below 25 percent each for mid and small-cap stocks.
To understand this better, let’s look at the SEBI mandated difference as well as the actual current portfolio allocation of multi and flexi-cap funds.
SEBI-mandated difference between multi and flexi-cap funds
Current Market Cap Allocation in Multi and Flexi-cap Funds
The allocation chart clearly shows that, on average, flexi-cap schemes are currently maintaining a large-cap heavy allocation, while multi-cap funds are focusing on small cap stocks to generate alpha.
In our view, both fund categories have a clear mandate, and will adopt distinct strategies to cater to investors with different risk profiles and return expectations.
The multi-cap category offers fund managers the scope to showcase their stock-picking skills and the potential to create alpha. The mandatory exposure across capitalisation does, however, pose a risk – the fund manager has limited scope to reduce exposure to any segment of market cap that is expected to do poorly at any point in time. The onus of managing the liquidity challenges that come with investing in small-cap stocks is on the AMC and its risk management frameworks.
Investors who are happy with a fixed allocation as their optimum exposure across capitalisation, and have a relatively high risk appetite can consider multi-cap funds. These investors would also need to have a longer investment horizon to allow for the fund’s strategies to bear fruit.
The flexi-cap category does not have any fixed minimum allocation across market capitalisation, making the fund manager’s conviction and skill at judging the right allocation important. The fund manager evaluates the growth potential of different companies, regardless of their market cap and invests in them. Flexi-cap managers can track when a particular market segment has become unattractive, and change the allocation to an alternative market segment that has performed well recently.
Investors who prefer flexible exposure across market capitalisation can thus consider flexi-cap funds. However, they should evaluate whether the fund is managed dynamically according to the prevalent opportunities in the market, and has delivered consistent performance that can meet their investment goals.
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