When investing in equities, we tend to agree mutual funds (MF) are a great avenue to explore especially for those who either don’t have much knowledge or time to spare in researching about which stocks to pick, etc. The greater risk in equity investing is the other than picking the right stock is the concentration towards it. If one were to expose higher allocation to a specific stock and if it continues to underperform then it becomes a burden over the investor.
MFs offer the way out for this dilemma as they offer diversification with the creation of portfolio. Also, the regulation of MF would allow lesser concentration and greater diversification. Of course, one could argue that the diversification or lesser allocation to a good performing stock or sector could be detrimental for higher returns. True, but the larger pain in investing is not about generating returns but losing out due to wrong allocation.
From the allocation aspect, large cap MF would score as less risky avenue than that of the mid-cap MF which in turn is relatively less risky than small-cap MF. The SEBI (Securities Exchange Board of India) has come out with regulations a few years back on the categorization of funds and thus curtailing cannibalising of themes, allowing to carry out a distinctiveness of each fund offering in the market. Accordingly, we’d multi-cap funds as category defined.
Till Jan of 2021, the regulation allowed the funds to remain discreet on the allocation of stocks of various capitalisations. The funds were having a relaxed way of approach in their allocation to mid & small cap but the ‘true to the label’ diktat from the regulator meant that the industry had to tow the line. With the request from the industry stakeholders, the regulator relented to have a new categorization in the form of flexi-cap funds.
The regulation with multi-cap fund makes the fund to have at least a quarter of allocation to each of large, mid and small cap funds. This makes the fund spread across the market caps with a higher allocation to one of those depending upon the prevailing market conditions and near-term prospects. This is where flexi cap funds are different where there’s no prevailing stipulation of allocation to any of the capitalization of stocks. Also, these funds could explore international equity as part of their strategy.
While in thesis, the multi-cap strategy looks attractive considering the allocations across the market, to fulfil the minimum requirement of allocation could lead to higher volatility. Many investors are drooling at the prospects of these funds looking at the performance in the last couple of years where there has been a considerable rally in the lower cap stocks. Extrapolating past performance could lead to disastrous results into the future and should be avoided. Operationally also, as the fund size gets large, it becomes difficult for the fund manager to allocate judiciously into these stocks. The lower capitalization of the stocks could upset the diversification and create liquidity issues.
Though, the regulation has its own merits in coming with a new category, the flexi cap fund could score well in terms of risk. The mandate for allocation to equity also increases the minimum equity to 75% while that of the flexi stands at 65%, though most of the funds would stick to almost 100% to equity. The option is at least available in flexi-cap funds to manoeuvre if the fund manager deems to reduce equity exposure. That lack of flexibility could hurt the performance intermittently when the lower cap stocks experience volatility.
The general gravitation of having a multi-cap fund in the core portfolio could be now replaced with flexi-cap fund from the risk perspective. The moderate to conservative investors could do benefit with this replacement for better risk adjusted returns in their portfolio. Moreover, investors could check where the additional 35% of the fund is being deployed and if it is to international equity then the investors should investigate the correlation with that of the domestic equity. For instance, the latest regulatory hurdle to pause allocations to International equity (non-ETF) route arose not from SEBI but RBI's age old threshold rule of $7bn. It also brings in additional complexity and should be considered while making decisions. Most importantly, investors should avoid investment exposure based on the past performance of any type of fund.
This article was originally published in "The Hans India" daily on 31st Jan 2021.