Multi-cap funds best bet for diversification

Whenever there is an increased volatility and market turmoil, we often witness a huge drawdown in the small and mid-cap stocks. This is imperious purely from their market capitalisation. So, when investors sell there would be a huge crunch in the liquidity which hits these stocks immediately.

This brings us to rebalance our portfolios that would take in to consideration of the market conditions. That would discount the exposure to mid and small caps while an increase in large caps is natural. 

Generally, when constructing a portfolio, we tend to have exposures at all levels or capitalisation of the stock markets. For this, we pick the mutual funds across the market caps proportionate to our risk profile. Instead, we could compensate by picking a multi-cap funds in the portfolio.

A multi-cap fund as the name suggests invests across the market irrespective of the market capitalisation of the stocks. This increases the flexibility for the fund manager to opt for the stocks depending upon the market opportunity which helps in aligning to the market conditions. 

With the SEBI categorisation of funds, the fund managers are now restricted to their fund objective in a cap-defined funds like large cap fund, but multi-cap funds come with elasticity across the capitalisation of the stocks.

For instance, if there is a downturn in the mid and small cap funds, that we witness currently, the fund manager could always limit the exposure to these stocks while increasing the contribution towards large cap stocks, which are relatively less volatile and also participate in the market growth. 

Also, while building a portfolio, especially for a beginner, it’s ideal to have a multi-cap fund along with a large cap fund than a mid/small cap fund and a value fund. The very diversification these funds provide a prudent way of investing.

These funds are sometimes called all-weather funds as these schemes align the portfolios according to market changes and the investor wouldn’t need to tinker their portfolios. 

The extensive diversification in these funds provides for a good risk to return perspective. As they capture the entire market breadth, these funds are relatively less volatile than the mid and small cap funds. These funds could potentially provide the best of both styles of investing i.e. value and growth while balancing a bit of risk. 

The larger universe to choose from also puts the fund manager in a tricky position on how to remain focus while continuing the diversification. The investment decisions to concentrate on a particular sector or type of stocks could backfire if the market realities didn’t match up to the expectations.

Despite their risk category placed in between large cap funds and mid cap funds, the dynamic moves could alter the risk associated with them completely. 

Due to the continuous handling of portfolio of these funds, the turnover ratio could also spike. Turnover is the percentage of the entire portfolio that’s changed i.e. due to the vast universe of stocks to choose from the fund manager could lead to increased trade (buy or sell) is higher when compared to a focused fund (large, mid and small).

This could lead to increased transaction costs and thus might impact the returns, especially the cost to returns. These funds are most suited for investors with moderate risk and seeking simplicity of diversification. While the aggressive investors could add these funds for balancing their portfolio.  (The author is co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)