Investing in Multi-Cap Funds

We have watched the mutual fund industry evolution in a variety of ways, whether in terms of products or rules. In October 2017, the Securities and Exchange Board of India (SEBI) issued a circular requiring mutual fund companies to have a standardised category with established requirements. This was a very welcome step by SEBI since it allowed investors to accurately identify the category and make a decision based on the characteristics of distinct categories. It also ordered the asset management companies (AMC) to have no more than one fund in each category. This also helped to reduce unneeded misunderstanding among investors.

The main goal of SEBI’s mutual fund rationalisation is to provide some standards in mutual funds and make mutual funds true to their label. However, SEBI discovered that there was one such group in equity mutual funds that did not live up to its name. This category included multi-cap funds. By definition, erstwhile multi-cap funds were free to invest throughout the market capitalisation. The primary goal of this fund was to alternate between Large-Cap, Mid-Cap and small-cap exposures. However, the majority of the funds focused solely on large-cap stocks and had relatively minimal allocations to mid-cap and small-cap stocks over market cycles.

In light of this, SEBI issued a circular in September 2020 requiring multi-cap funds to invest at least 25 per cent each in large-cap, mid-cap and small-cap stocks. This caused turmoil in the financial markets since investors expected a significant sell-off in large-cap companies along with increased purchasing in mid-cap and small-cap firms. This concept, however, was put to rest when SEBI approved a new mutual fund category called as flexi-cap in November 2020. Flexi-cap funds are free to invest throughout the market capitalisation spectrum.

Despite all of this, many investors are still unsure what multicap funds are and if it makes sense to invest in them at all. So, keep reading to learn more about multi-cap funds, their performance in contrast to flexi-cap funds, large & mid-cap funds and its benchmark index, and who should consider investing in them.

The graph above clearly illustrates that multi-cap funds’ asset under management (AUM) contribution to the total equity category is constantly increasing. However, in comparison to other equity categories, this provides one of the least. However, new fund offers (NFO) in the multi-cap category are gaining popularity, with SBI Multi-Cap Fund having a blockbuster NFO collecting over `8,170 crore. As a result, interest in this category of new standards is growing.

What are Multi-Cap Funds?
According to the SEBI’s circular on mutual fund rationalisation, which went into effect in June 2018, SEBI defined the large-cap, mid-cap and small-cap stocks, with the list being provided semi-annually by the Association of Mutual Funds in India (AMFI).

According to SEBI, the top 100 publicly traded stocks based on total market capitalisation would be considered large-cap. The following 150 stocks, ranked 101st to 250th in terms of total market capitalisation, are classified as mid-cap, while those ranked 251st and higher are classified as small-cap.

As previously stated, multi-cap funds must invest at least 75 percent of their total assets in equity and associated instruments and allocate at least 25 per cent each of their assets to large-cap, mid-cap and small-cap stocks, according to SEBI standards. Although a multi-cap fund might be a good alternative for diversification, we cannot disregard the risk that the fund has because it has a minimum of 50 per cent exposure to mid-cap and small-cap firms. The good news is that the remaining 25 per cent is the allocation leeway available with the fund manager. As a result, the majority of this is invested in large-cap companies.

Asset Allocation
In this part, we will examine the average asset allocation of multi-cap funds and compare it to that of flexi-cap funds and large & mid-cap funds.Multi-cap funds, flexi-cap funds and large & mid-cap funds are all heavy on large-caps, as shown in the above three graphs. However, flexi-cap funds have the biggest allocation to large-caps (66.4 per cent) of the three. As a result, flexi-cap funds are a smart alternative for investors with a low risk tolerance. Large & mid-cap funds are appropriate for investors with a moderate risk profile, while multi-cap funds are also appropriate for individuals with a moderate risk profile seeking exposure to mid-caps and small-caps. This is because among the three types of equity funds discussed above multi-cap has the biggest allocation (17 per cent) to small-cap companies.

Performance
The performance of any investment is what makes you want to invest in it. So, now we will look at the performance of multicap funds and compare it to that of flexi-cap funds, large & mid-cap funds and benchmark index.. In this case, we will be comparing performance in two ways: returns and risk. We calculated the three-year rolling returns of multi-cap funds, flexi-cap funds large & mid-cap funds and the Nifty 500 Multi-Cap 50:25:25 Total Returns Index (TRI) for returns. Furthermore, for risk, we would consider the maximum drawdown. We examined the information from May 2012 to April 2022.

As the graph above shows, there is no consistent performance across multi-cap, flexi-cap and large & mid-cap funds. The average three-year rolling returns of multi-cap funds, flexi-cap funds and large & mid-cap funds were 14.2 per cent, 13.3 per cent and 14.1 per cent, respectively. As a result, we can conclude that multi-cap funds, as well as large & mid-cap funds, perform well in terms of long-term performance. However, let’s take a closer look at their three-year rolling returns to see how they are dispersed.

The distribution of three-year rolling returns is seen in the table above. Only 4.2 per cent of the time, out of 1,721 rolling returns observations, did multi-cap funds have negative returns. However, flexi-cap funds have suffered the fewest negative returns (3 per cent of the times). Surprisingly, the Nifty 500 Multi-Cap 50:25:25 TRI had negative returns of 5.8 per cent of the times.

On the plus side, multi-cap funds, flexi-cap funds, large & mid-cap funds and also Nifty 500 Multi-Cap 50:25:25 TRI gave returns ranging from 10 per cent to 30 per cent the majority of the time (70 per cent) with Nifty 500 Multi-Cap 50:25:25 TRI experiencing returns ranging from 10 per cent to 30 per cent 77 per cent of the time, while multi-cap funds experienced it 73 per cent of the time. In terms of returns, it appears that the flexi-cap fund makes more sense. Risk, on the other hand, cannot be disregarded.

If we look at the risks through the prism of maximum drawdown, the Nifty 500 Multi-Cap 50:25:25 TRI had the most drawdowns, whereas flexi-cap funds have suffered drawdowns less frequently.

If we look at the maximum drawdown, the Nifty 500 Multi-Cap 50:25:25 experienced the most agony, followed by multi-cap funds and large & mid-cap funds. Although flexi-cap funds experienced less suffering, it is still not much lower. As a result, we can state that flexi-cap funds outperform multi-cap funds and large & mid-cap funds in terms of risk.

Advantages of Investing in Multi-Cap Funds
1) When we look at the market segments, there are no apparent constant winners. Different market segments surpass one other during different market cycles. In a down market, large-cap stocks, for example, outperform mid-caps and small-caps. During the market upswing, however, mid-caps and small-caps outperform large-caps.

As shown in the table above, there is no clear champion across all market segments. As a result, investing across them makes more sense because it allows you to lessen your reliance on a particular market segment

2) When compared to large-cap funds or even funds with more than 65 per cent to 70 per cent exposure to large-cap companies, multi-cap funds have exposure to a wide number of sectors where large-cap funds have no representation. Furthermore, as compared to mid-cap and small-cap funds, multi-cap funds dedicate at least 25 per cent of their assets to large-cap companies, which provide stability in volatile market situations.

3) Multi-cap funds spend approximately half of their total portfolio in mid-cap and small-cap equities. Mid-cap and small-cap stocks beat large-cap companies over the long haul. This is because outliers exist in mid-cap and small-cap stocks, and it is these outliers that have the ability to deliver larger returns.

4) When compared to large-cap, large & mid-cap, mid-cap and even flexi-cap funds, multi-cap funds have a significantly broader universe of stocks to invest in. Because the other categories stated above have maximum exposure to the top 250 companies, multi-cap funds can have exposure beyond that.

5) When compared to large-cap funds and even large-capbiased funds, multi-cap funds have the potential to generate larger alphas. Large-cap companies often have more institutional ownership since they are more thoroughly studied than mid-cap and small-cap companies. As a result, price discovery in large-cap companies is faster, making it difficult for fund managers to locate cheap stocks. However, because multi-cap funds invest half of their portfolio in mid-cap and small-cap stocks, the fund manager may be able to identify firms that are trading at large discounts to their true value, resulting in alpha for investors over a relatively long investment horizon.

6) Subject to SEBI-mandated minimum allocation requirements, multi-cap funds have some leeway in increasing or decreasing their market-cap allocations based on market conditions. However, it is crucial to highlight that because flexi-cap funds have no market-cap constraints, they offer greater flexibility than multi-cap funds. However, we have found that flexi-cap funds are typically large-cap-skewed.

Who Should Invest in Multi-Cap Funds?
Because of their larger exposure to mid-cap and small-cap companies, multi-cap funds have a higher risk than flexi-cap funds and large & mid-cap funds. However, as compared to its benchmark, the Nifty 500 Multi-Cap 50:25:25 TRI, they perform admirably in terms of downside risk management. Furthermore, multi-cap funds outperform flexi-cap funds, large & mid-cap funds and the Nifty 500 Multi-Cap 50:25:25 TRI interms of returns. However, this fund is not intended for everyone. Those who already invest in large-cap or large-capskewed funds and want to get exposure to mid-caps and small-caps might consider multi-cap funds.

Furthermore, people who want exposure to mid-caps and small-caps but do not want to risk it by investing in mid-cap and small-cap funds separately might choose multi-cap funds. Investors with conservative risk profiles, on the other hand, should shun multi-cap funds in favour of flexi-cap funds. Those with an aggressive risk profile should avoid multi-cap funds as well, since they would be better suited investing individually in mid-cap and small-cap funds. As a result, multi-cap funds are better suited for investors with a moderate risk tolerance.

Conclusion Following SEBI’s change in multi-cap fund requirements, several funds migrated to the newest category known as flexi-cap funds. With these new rules, the risk of investing in multi-cap funds has increased because at least 50 per cent of the funds’ assets are now dedicated to mid-cap and small-cap firms. When compared to flexi-cap funds and even large & mid-cap funds, these funds produce higher long-term returns. However, based on its risk and return profile, it is appropriate for investors seeking mid-cap and small-cap exposure who have a moderate risk tolerance. Otherwise, this makes no sense to others. In fact, tactically managing a portfolio of large-cap, mid-cap and small-cap funds will yield you superior riskadjusted returns than multi-cap funds.