The Indian equity market performed very well in 2021 on the back of economic recovery, robust corporate earnings growth, comfortable liquidity conditions, and active participation from retail investors. The market rally during the year was broad-based; most stocks and sectors participated in the rally. As a result, mutual funds that invest across market caps benefitted immensely.

Among the equity mutual fund categories that invest across market caps, Multi-cap Funds and Flexi-cap Funds are the prominent ones. Despite both funds investing across market caps viz. large-caps, mid-caps, and small-caps, Multi-cap Funds outperformed Flexi-cap Funds by a noticeable margin in 2021.

To find out why Multi-cap Funds outperformed Flexi-cap Funds, we need to first understand the difference between the two categories…

What are Multi-cap Funds?

In September last year, SEBI changed the definition of Multi-cap funds. Multi-cap funds now have the 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. Multi-cap funds have to maintain the minimum allocation of 25% in each market cap, regardless of the market conditions.

What are Flexi-cap Funds?

SEBI in November 2020 introduced a new equity mutual fund category known as Flexi-cap Funds. Flexi Cap Funds are characterised as schemes investing a minimum of 65% of their assets in equity and equity-related instruments with dynamic allocation across large-cap, mid-cap, and small-cap stocks. Such flexibility allows the fund manager to invest wherever value and opportunities are available without any restriction on market cap.

Table: Multi-cap Funds outperformed Flexi-cap Funds in 2021

Category Top performing fund (%) Worst performing fund (%) Category average (%) Benchmark return (%)
Multi-cap Fund 50.65 18.28 36.85 25.46
Flexi-cap Fund 41.41 10.95 26.81 25.46

Data on a YTD basis as of December 20, 2021
Direct Plan – Growth Option considered
(Source: ACE MF, PersonalFN Research)  

Why Multi-cap Funds outperformed Flexi-cap Funds in 2021

In my earlier article, I had mentioned how a broad-based market rally took the stocks of smaller companies to new highs. During the year, investors remained upbeat on the high-beta, and high growth smaller companies that were beaten down, which they perceived would do well in the long-term as we walk out of the COVID-19 pandemic. Consequently, despite the recent sharp correction, mid-cap and small-cap stocks did exceptionally well in 2021 compared to their large-cap counterparts.

Since Multi-cap Funds hold higher allocation to mid-cap and small-cap stocks, the category benefitted from the extraordinary rise in prices of smaller companies. On the other hand, Flexi-cap Funds held lower allocation to the stocks in the mid-cap and small-cap segment.

Graph: Average market cap allocation of Multi-cap Fund and Flexi-cap Fund category

Graph 1

Data as of November 30, 2021
(Source: ACE MF, PersonalFN Research)  

Will Multi-cap Funds continue to do better than Flexi-cap Funds in 2022?

It is important to note that how these categories performed in the current year is in no way indicative of future performance.

During bull market phases, such as the one we have witnessed during the year, Multi-cap funds can outpace Flexi-cap funds. Mid-cap and small-cap stocks generally soar higher than large-cap stocks during a broad-based market rally. Consequentially, Multi-cap funds can benefit from higher allocation in the segment and reward investors with higher gains.

However, if the volatility in the equity market intensifies in the coming months, which is likely, stocks in the mid-cap and small-cap segment may face liquidity constraints and high volatility. In other words, if the bullish momentum slows down in 2022, Multi-cap funds can record lower returns than Flexi-cap Funds. It can even witness a higher drawdown compared to Flexi-cap funds if the market sentiment turns bearish. However, the presence of large-caps in the portfolio can offset some of the volatility.

[Read: Omicron Scare Sends Market in a Tizzy. Should You Redeem Your Equity Mutual Fund Investments Now?]

On the other hand, most Flexi-cap Funds currently hold a predominantly large-cap biased portfolio with around 65%-80% allocation in the segment. Going ahead too we can expect Flexi-cap Funds’ portfolio/s to be skewed towards large-caps, which can stabilize the portfolio if the market turns volatile. Additionally, the category can tactically allocate assets in the mid-cap and small-cap segments in line with the market conditions.

The category can even reduce the exposure to smaller caps to zero if the situation so requires. Such flexibility coupled with the higher large-cap allocation can aid in stabilizing the portfolio during bearish phases. Fund managers of Multi-cap Funds do not have much flexibility to swing allocation to one particular market capitalisation segment in a market phase.

That said, both categories can reward investors with superior gains over the long term since they have the freedom to select from a large universe of stocks. This gives fund managers greater scope to identify alpha-generating opportunities across the market cap spectrum. However, choosing the best Multi-cap or Flexi-cap scheme that aligns with your financial needs is crucial.

Which is a better fit for your portfolio?

After SEBI changed the definition of Multi-cap Funds, most erstwhile schemes in the category have now shifted to Flexi-cap Funds. Meanwhile, mutual fund houses launched several new Multi-cap and Flexi-cap schemes in recent months.

Both Multi-cap Funds and Flexi-cap Funds carry significant allocation to stocks in the mid-cap and small-cap segment. Therefore, these categories are suitable for investors with a high risk profile and an investment horizon of at least 5 years. When you invest in these categories, you can benefit from the growth potential of mid-cap and small-cap stocks as well as the stability of large-caps.

Being distinct in nature, the performance of the two categories can differ in different market phases. However, both the categories have the potential to identify attractive opportunities across market caps and build solid wealth for investors over the long term.

The decision on whether to invest in a Multi-cap fund or a Flexi-cap fund should depend on your financial goals, risk profile, investment horizon, and whether it aligns with the investment objective of the scheme.

Whichever category you choose, ensure that you invest in worthy schemes after evaluating their performance on various qualitative and quantitative parameters. Avoid investing in either category based on its short-term performance.

[Read: How to Select Top Equity Mutual Funds for Your Portfolio]

Do note that mutual fund houses have launched several new Multi-cap Funds and Flexi-cap Funds in the recent months. However, it is advisable to select schemes that have a reliable long term performance record.

Additionally, it is crucial to study the portfolio characteristics of the schemes to assess how it has diversified the portfolio across large-caps, mid-caps, and small-caps, the top-10 constituents of the portfolio, and top-5 sector exposure. If the portfolio is not appropriately diversified and the quality of its holdings is poor, the scheme could expose your investment to high risk.

Also, check how the Multi-cap Fund/Flexi-cap Fund has performed in the past (across bull and bear market phases) and how it fares on risk-reward parameters (denoted by the Standard Deviation, Sharpe ratio, Sortino ratio, etc.). As you know, past returns are not an indication of future returns, but they may provide you with a better understanding of the fund to select worthy ones.

Furthermore, ensure that the fund house has a significant performance record and follows robust investment processes with adequate risk management systems.

Lastly, prefer the SIP mode of investment to mitigate the impact of volatility and benefit from the power of compounding.

This article first appeared on PersonalFN here

Leave a Reply

Your email address will not be published. Required fields are marked *