The Mutual Fund Show: Should You Consider Investing In Multi-Cap Funds?

Radhika Gupta: I think the history was a little bit old and more has happened in that history. Now, when we had the option, our fund was running as a flexi-cap fund in nature. It was benchmarked to the NSE 500. It had about 70% or 60% large-cap exposure and the balance was mid and small. We always focus on creating minimal disruption to existing investors. So, we took what was our erstwhile multi-cap fund and made it a flexi-cap fund, because we didn't want to do unnecessary buying and selling of securities. We had a particular mandate, and we migrated our fund.

As far as launching a new fund is concerned, we are a little thoughtful. We don't launch NFOs just because the category has opened. We like to evaluate market conditions, we like to evaluate liquidity, and we like to evaluate our basket more completely. Now, I think it has been a few years since this event happened. One, our own equity capabilities and team has expanded substantially. But I think, the clear case, the clear differentiation between both funds is available. SEBI has also got mandatory benchmarking on both schemes, and the current flexi-cap schemes are benchmarked to the NSE 500. And, NSE 500 is a benchmark with 75% large-cap exposure, which means that your flexi-cap fund is now going to run as a predominantly large-cap fund. And really, benchmarks govern how schemes are run. We feel that if you look at the structure of the Indian market today, really mid and small-cap as a segment has expanded.

Twenty years ago, the average size of a large-cap company was Rs 3,000 crore, while today the average size of a small-cap company is Rs 12,000 crore. And, if you really want to capture the best of India's opportunities, we do believe it can't be only large cap. Because, when banking and financial services leaders are present in large caps, many of the leaders in capital goods, in China plus one theme, in diagnostics and capital markets are present in mid and small cap. So, the default portfolio has to now move to a blend of large, mid and small. The multi-cap fund construct lets us do it. Its benchmark is a lot more aligned to equal participation across market caps and that is why we felt it is a good time to launch. In addition, I think we do have the mid and small-cap capability, which this fund requires.

Trideep Bhattacharya: In fact, I would turn it around and say that while we have a very successful mid and small-cap fund with robust track record, and we have been strong proponents of mid and small-cap investing over the last couple of years, given where valuations are, given that we have seen already a 40% to 50% rally in mid and small caps, we think that the incremental money today should probably go into a balanced portfolio—balanced across large, mid and small-cap stocks.

So when we, at Edelweiss, sat together to think what could be that alternative—what NFO to come with, if we do come up with—rather than going with a thematic fund, we thought this is the best solution for investors given where valuations are for mid and small caps, and at present as an alternative to investors overall.

The other point I would say is that after having seen a good amount of rally in mid and small caps, there are some pockets of irrational exuberance that are present in that segment. But that is not to say that mid and small caps as a space are uninvestable.

In fact, we believe that this is India's decade, and over the next four or five years, once we navigate through this volatility, which includes national elections, India could see a strong runway for growth, driven by various factors and to capture that, one needs to have exposure in mid and small caps.

What we are saying now is, we need to be a little more selective. A multi-cap portfolio or a multi-cap construct helps us do that in the context of one portfolio. And hence, we are kind of taking the multi-cap approach of investing for incremental money, and that is our suggestion for investors as well.

Radhika Gupta: I will answer the second question first. I think this will be the default portfolio for the future because through Trideep’ s point and my point earlier, if you look at the structure of the Indian economy, I think you need to capture opportunities across market cap. And we as a (fund) house are a big believer in bundled solutions. You can't have mid and small-cap exposure today. And when markets change, you do market timing. Firstly, it is very hard to do market timing. You switch to large cap, you pay a lot of tax, then you move to mid and small cap again. I think the power of having things in one solution is really underrated. We have seen that with the success of hybrid funds. We have seen that with the success of our own Gold and silver funds. I think having a single solution is very powerful, in a world where you pay taxes and there are costs to rebalancing. So, I think the product is really for everyone. In that sense, it is your default equity allocator. If you want to call it dumb asset allocation, call it that.

Now, as far as volatility is concerned, I think we intend to run this as a broadly 40% large cap, 30% mid, 30% small fund, which means 60% is mid and small-cap exposure. And of course, we are making that fact amply clear. If we wanted to run one more large cap biased fund, there was frankly no need to launch that fund.

Will the risk be a notch higher? Of course, it will be a notch higher than running a pure play large-cap fund. Will the returns be a notch higher? I think historical data suggests that the returns will also be a couple of notches higher. Interestingly, when we look at the data on a risk-adjusted return basis, I think multi cap stacks up well. So, investors are being rewarded for the incremental risks that they are taking.

Trideep Bhattacharya: I think overall, if you look at it from a bit of an equity market outlook it will probably set the context. And hence, the portfolio be would run the way it will be.

If you look at the macro today, whether you look at global macro or local macro, punctuated by the fact that the 10-year bond yields in the United States have reached the levels of 2007, the weaker global recovery, etc, I think it makes sense to say that global and local macro is reasonably negative.

Hence, the way we want to run the multi-cap fund on an ongoing basis is to basically focus the portfolio on what I call pockets of earnings resilience. These pockets of earnings resilience are selected on a bottom-up basis, and basically present themselves with you know earnings, tailwinds which are more than just normal ones. And what that means is, even in a tough macro environment, these are the areas where we will have limited earnings downgrades if any. Or, in a positive macro environment, we could see a better earnings surplus to come through. This is what I would call heads-I-win-more, tails-I-lose-less kind of way of thinking.

Based on this sort of construct, we have come about five areas of pockets of earnings resilience, which is where about 70% to 75% of our fund will be oriented towards.

These five areas in brief are: First, we are positive about capex as a theme. We think that we are in the middle of a manufacturing upcycle, driven by the private sector capex over the next two to three years.

Second, we think that lending financials are in a good spot right now. I would call it a going through a Goldilocks moment, with both growth and asset quality in the right place.

Third, we think that direct and indirect plays of real estate are a good place to be, because real estate is in the middle of a five and seven-year upcycle and we are somewhere in the middle and there is some more room to go.

The fourth and the fifth areas are more emerging. And hence, a multi-cap construct helps us better. The fourth area is defence, where indigenisation of defence has given a decadal opportunity for Indian corporates. And, we think, particularly stocks in mid and small cap can capitalise on the same.

And finally, EMS (Electronic Manufacturing Systems), as a theme, in my opinion is probably even a longer-dated theme overall. The sector itself is growing at about 30%.

The point here really is that in these areas, there is something more going on than the normal business conditions. And, we think a bottom-up portfolio, constructed in and around these areas could actually kind of present to investors, a portfolio which is relatively insulated, but at the same time is well-oriented towards growth, and valuations are still not excessive.

Trideep Bhattacharya: I think the overarching theme, if you were to look at where we are taking the alpha bets, it will be higher in manufacturing than in financials. Today, financials is a fairly broad construct by the way. We have lending financials, we have non-lending financials in the form of capital market players, depositories, and a whole bunch of other players. So, in that context, we are talking about a specific sub-segment within financials, which is lending financials which we are positive on. Whereas in manufacturing, we are more broad-based—whether it is capital goods, whether it is construction, and also defence, which could be a sub sector if you can call it that way.

So, we are more broadly overweight in manufacturing, underweight or selective in consumption. Our consumption weighted bets are more oriented towards urban consumption bets. And in that context, financials will come second or third in areas that we are betting on. Because, we are betting on a sub-segment which is lending financials. And it is, in a way, linked to manufacturing as a theme because manufacturing as you know, needs capital creation and as part of capital creation, you need credit growth and credit growth is what banks provide. So, it is linked in a way. But we want to capture that part of the financials rather than anything and everything that falls under that category.

Radhika Gupta: I wanted to make a tiny point. I think one of the things that distinguishes multi cap is that if you look at the large-cap universe, the flexi-cap universe because of this NSE 500 benchmark, financials end up being 35% to 40% of that benchmark, which is why you see what you said, portfolios heavily dominated by financials. In a multi-cap construct, because the benchmark is a lot more spread across sectors, your sectoral split is a lot less concentrated. Trideep talked about what we intend to do, but the portfolio structurally lets us be a lot less concentrated towards financials.

Prableen Bajpai: I think multi cap is the newest category in the diversified space. SEBI, in 2020, came up with the observation that the multi caps then had almost 80% in large-cap stocks and that is why they mandated 25% allocation each to large, mid and small caps. Majority of the fund houses actually chose to sort of continue with the large-cap tilt and change the structure to flexi cap, which was essentially the earlier multi cap. And then, it continued as a flexi cap.

If you look at the 22 funds as of now, there are only about four funds that are actually 10 years old and about two others which are six and four years old. So, there are not too many funds which have a very old track record. Very few continued.

Now, the rationale that they have given, I think it is right, because a lot of broader categories diversified space funds that we see are usually large-cap tilted and definitely the flexi-cap category is one of them.

So, multi-cap space, I think is a good combination of you know, different market caps. It definitely brings in the true diversification in terms of market cap, but it also brings in the added risk, because 50% of your allocations are towards the small and mid caps.

Having said that, I think it is not a category which is for everybody. It is for those who understand the kind of risks that they are going to undertake.

And I think, a little trouble here is because the restructuring happened in 2020. And if we look at how the large, mid and small caps have performed since then—2020 was phenomenal for all the three spaces. If you look at Nifty 50, 150, and the mid-caps, the small cap 250 index, all of them were really good in terms of performance. Then, 2021 again, was a phenomenal year. In 2022, we saw some dullness, but 2023 again has been great. So, till now, whatever we have seen in the category is good performance and we haven't seen a time like 2018, where the large caps were up by 3% and mid-cap index was down by 13% and small cap was down by about 27%. So, I think the true potential will only be revealed with time. But yes, I think it is a good combination. It is a good category to be young and yet to be tested.

Vishal Dhawan: I think it is a good idea to step back a little bit and ask yourself to say, you know, what is an investor really seeking when he chooses to go to a category which is flexible in its approach—whether it is a flexi-cap category, or a multi-cap category.

Our experience has been that most investors are saying let us leave it to the fund manager to decide on whether he wants to be in a larger company, a small-sized company, or a midsized company, because I don't have the skill to make that decision in any form whatsoever. And, I think my fund manager will do that well. Now, the moment that becomes the approach of the investor, clearly the flexi-cap category becomes a default choice, because it doesn't have any of the restrictions that the multi-cap category comes with, in terms of having a minimum 25% in mid cap, minimum 25% in small cap, and 25% in the large cap, and then the rest you can do whatever you want. So, very clearly, I think there is a very natural fit of the flexi-cap category with the investors’ need. And therefore, our sense is that, if this question is posed to the investor and sort of explained to him in the way that these are structured, it is most likely that in most environments the investor would prefer a flexi-cap fund over a multi-cap fund.

Prableen Bajpai: It is a different category, because flexi cap is like the multi caps became the flexi cap. I think, that is why we have this comparison. And it is quite natural.

I personally feel that because we don't have track records, if you look at Nifty 500 returns and if we look at Nifty 50-25-25—there's another index that is there—just for comparison’s sake, definitely the one which has the mid-cap and small-cap exposure has outperformed over different time periods. And, I am looking at SIP returns here, because I think multi-cap as a category—because we are having exposure to small caps and that is a decent exposure 25% and to mid-caps another 25% at all times—I think a staggered approach, or an SIP approach is going to be better here definitely. So, if you look at the returns in terms of SIPs, they have outperformed and it should, because we are also undertaking higher risks.

And, the majority of the flexi caps moved into the flexi-cap category, because they wanted to probably maintain the large-cap tilt. So, initially, when SEBI came up with the restructuring—that you will have to define what is large cap, mid cap—it gave a three-year period to all AMCs. But, it came up with the observation that none of them were actually using the flexibility to the level that they should have been probably using, and that is why we have this structured product. But I think, it is a good product for those who understand the kind of risks that they are going to undertake. I do feel that it does have the return potential. So, I would go in for a multi cap for those who understand the matrix of how the fund is structured, and also who are looking to have a higher mid and small-cap exposure through a diversified fund.

Prableen Bajpai: I think it is a good fit in a combination for somebody who has passive funds as well. So, let us say, somebody having a long-term portfolio has a large-cap passive fund, in combination with a midcap 150 index fund. So that is your core. And here, the multi-cap space can actually give them some exposure to large and mid-caps, and in pockets which you know where probably there is scope for value investing.

Vishal Dhawan: I think there are two or three different elements here that need to be looked at very closely. First of all, you know as an investor, or even as an advisor, there are a set of people who like discipline to be very high and the ranges that are available to be limited for fund manager in order to be able to make choices in terms of which market cap he or she can buy into. Now, those sets of investors will find multi cap very interesting, because that 25% flexibility is all that the fund manager has to be able to make those decisions, in contrast to something like a flexi-cap fund, where literally you are leaving it up to the fund managers to decide whatever he or she wants to do. And therefore, those sets of people who have great trust in fund managers and their abilities will find it comfortable to go to a flexi-cap fund. Those who want to give that flexibility but with limits defined around it will prefer to look at multi cap as an alternative.

The second thing that can be an important part of this decision is essentially to say how much of this is being made on the basis of the last few years of track records of multi-cap funds versus you know, flexi cap. And clearly, because the mid-cap and small-cap space have done relatively better than large caps, you could end up finding that on a trailing basis, multi-cap funds could actually be delivering or have delivered a higher rate of return thus far, which could change if the mid-cap and small-cap space, start to underperform going forward. And therefore, if your decision is being made on the basis of past returns, there is a real risk that you could end up buying the wrong one, because you made it on that basis.

Prableen Bajpai: I totally agree with what Vishal has mentioned about—that recency bias can be very high at this point. I think that is something that investors have to be very careful about and that is why I think the staggered approach to the category generally is better.

We don't have too many with a track record and that too when the track record is available, it is not for the structure, you know that wasn't in place, it is hard to say how they will perform in terms of this rigid structure going forward. But if I have to name certain funds, Nippon is one and I will name three others from HDFC, SBI and Kotak. And this is the rationale that all these fund houses have—they delivered great performances in their respective mid-cap and small-cap categories. So, I think these are fund houses which have the expertise to manage these market cap companies. The stock picking has been great because the individual schemes from these categories have done quite well and have been consistent performance. So, I think these are the four AMCs that I would go with and other than ICICI, Invesco, I think they look fine too. And of course, it comes with a disclaimer that investors have to do their own due diligence before investing.

Vishal Dhawan: I think, in addition to the staggered approach that Prableen mentioned, it is also important to have a long enough investment horizon to these funds. Clearly, we think, at least seven to 10 years for you to be able to ride through, you know, what can happen with mid and small caps.

I think two of the funds that Prableen mentioned, which are essentially Nippon and HDFC, are both funds that we would suggest investors to look at as well. HDFC is about to finish three years in December. So, in the normal course, we would have been a little hesitant, but like Prableen said, you know, there are not a lot of track records in this category, especially, you know, as multi-cap funds with the mandate that SEBI put out. So, therefore, those would be our top two choices if investors are looking as long as it takes with at least a seven-to-10-year view.