Diversification is an important part of portfolio management. Diversification can not only reduce portfolio risk but also help capture a wider range of potential opportunities.
One mutual fund category that offers broad market diversification through a single investment is the multi cap fund, which has the flexibility to invest across large cap, mid cap, and small cap stocks.
In this article, we explain how multi cap funds’ diversification works and how these funds can be a suitable addition to an investment portfolio. We also discuss their potential benefits, risks, and other key considerations.
Table of contents
What is portfolio diversification?
Portfolio diversification involves spreading investments across various asset classes, sectors, or geographies to potentially mitigate risk. By diversifying, investors can reduce the impact of an under-performing instrument, asset class or sector on the overall portfolio and reduce over-reliance on any single component for growth potential.
Mutual funds are inherently diversified, because each scheme invests in a basket of securities. However, some categories offer more diversification than the rest. Multi cap funds are one such example.
How multi cap funds diversification works
Multi cap funds are equity-oriented mutual funds that invest across large cap, mid cap, and small cap companies. As per SEBI guidelines, these funds must allocate a minimum of 25% each to large cap, mid cap, and small cap stocks. This mandated allocation ensures that investors gain structured exposure to a broad spectrum of the market. Here are the features of each component of these funds.
- Large cap stocks: These are typically stocks of well-established companies (ranked 1 to 100 on stock exchanges by market capitalisation) with a track record of relative steady long-term growth.
- Mid cap stocks: Ranked between 101 to 250 on the stock exchange, these companies offer higher growth potential over the long term, because they are still in their expansion stage, but come with higher volatility.
- Small cap stocks: These are companies listed 251 and beyond with a long runway for growth. They can offer the potential for outperformance in the long horizon but come with even higher volatility, especially over the short to mid term.
By investing across these segments, multi cap funds aim to balance the higher long-term growth potential of mid and small cap stocks with relative stability of large caps.
Read Also: Direct vs Regular Plan in Multi Cap Funds: Which is Better?
Key benefits of investing in multi cap funds
Potential benefits of multi cap funds for investors seeking a balanced equity exposure:
- Broad market participation: Because they invest in large, mid, and small companies, multi cap funds help you participate in the potential growth of the entire market.
- Diversification and risk mitigation: By not concentrating in one segment, they can mitigate market cap-specific risk during volatile periods.
- Growth potential with relative stability: The large cap stocks in the fund contribute relative stability and the potential for steady returns in the long term. Meanwhile the mid cap and small cap stocks offer higher growth potential, especially during market rallies.
- Response to market cycles: With exposure to all market segments, multi cap funds may be more strategically positioned to capture growth opportunities in different market phases compared to equity funds focused only on one market cap.
- Convenience and simplicity: Instead of buying separate large cap, mid cap, and small cap funds, an investor can get diversified exposure through one fund. This simplifies portfolio management.
Investors can also use SIP investment plan, which can potentially smooth out market fluctuations and average out the total cost of investment.
Risks involved in multi cap funds
While multi cap funds offer diversification, they are not without risk. Some of these include:
- Market risk: Being equity-oriented, these funds are subject to risks like slowdowns, volatility and bear markets.
- Mid and small cap volatility: These segments can experience sharp price fluctuations, impacting the fund's performance, especially over the short to mid term.
- Liquidity risk: Small cap stocks may have lower liquidity, making it challenging to execute large transactions without affecting the stock price during stressed market conditions.
- Managerial risk: The fund's performance is influenced by the fund manager's decisions.
Multi cap funds vs other equity funds
Understanding the distinctions between multi cap funds and other equity funds is important for making informed investment decisions:
- Large cap funds: Focus predominantly on large cap stocks, offering relative stability but less aggressive growth potential compared to smaller cap mutual funds.
- Mid cap and small cap funds: Concentrate on mid cap and small cap stocks, offering higher growth potential in some market conditions but entailing increased volatility, especially over the short to mid term.
- Flexi cap funds: Have the flexibility to invest across market capitalisations without mandated allocations, allowing fund managers to dynamically adjust the portfolio based on market conditions.
Who may invest in multi cap funds?
Multi cap funds may be suitable for:
- Investors seeking diversification: Those looking to spread investments across various market caps.
- Long-term investors: Individuals with a long investment horizon aiming for potential wealth creation over time with some level of risk mitigation owing to the large cap allocation.
- Those who can stomach NAV fluctuations: Investors comfortable with high volatility risk, especially in the short term.
Investors must align investment choices with individual financial goals and risk tolerance.
Things to consider before investing
Before investing in multi cap funds, consider the following:
- Investment horizon: A longer investment period may help in mitigating the impact of short to mid term market volatility.
- Risk appetite: Assess your comfort with the inherent risks associated with equity-oriented investments.
- Fund performance: Review the fund's historical performance*.
- Expense ratio: Understand the costs associated with the fund, as higher expenses can impact net potential returns, especially over a long horizon.
- Fund manager's track record: Evaluate the experience and track record of the fund manager.
*Past performance may or may not be sustained in future
Using tools like an SIP calculator can help plan investments based on the tool’s projections of the potential final corpus size.
Taxation on multi cap funds in India
Tax implications are a vital aspect of investing. Multi cap funds are taxed as equity-oriented funds. The structure is as follows:
- Short-term capital gains: If units are redeemed within 12 months, gains are taxed at 20%.
- Long-term capital gains: If units are redeemed after 12 months, gains of up to Rs. 1.25 lakh in a financial year are tax exempt. Thereon, they are taxed at 12.5%.
Read Also: Multi Cap Vs Multi Asset Allocation Fund: Differences and Which is Better?
How to choose the multi cap funds
Selecting an appropriate multi cap fund involves:
- Analysing fund performance: Compare the fund's returns with its benchmark and peer funds. (Past performance may or may not be sustained in future).
- Understanding investment strategy: Review the fund's investment approach and asset allocation.
- Evaluating risk measures: Consider metrics like standard deviation, Sharpe ratio and beta to understand volatility.
- Reviewing portfolio holdings: Assess the sectors and stocks the fund invests in to ensure alignment with your investment preferences.
Consulting a financial advisor can help you choose multi cap mutual funds suited to your long-term goals and risk appetite.
Conclusion
Multi cap funds provide a way to diversify your portfolio across large, mid, and small cap stocks within a single scheme. This broad market exposure can potentially help with finding varied growth opportunities while trying to limit the ways a volatile market can risk your capital. While there are important benefits to multi cap funds, individuals must assess their risk tolerance, time horizon and financial objectives before investing.
FAQs:
What are multi cap mutual funds?
Multi cap mutual funds are equity mutual funds that invest in large, mid, and small caps. SEBI mandates that the fund must invest at least 25% in each of these segments.
How do multi cap funds add value to diversification?
Multi cap funds offer diversification because they invest in all market capitalisations, which can potentially mitigate risk and capture wide growth opportunities by providing exposure to different parts of the market.
Are multi cap funds suitable for long term investing?
Yes, multi cap funds are generally appropriate for investors who are targeting long horizons for investing and looking to potentially create wealth while being comfortable with some degree of risk, especially over the short to mid term.
What risks do multi cap funds have?
Risks associated with multi cap funds include market risks, notably short to mid term volatility, potential liquidity challenges, and managerial risk.
How are multi cap funds and flexi cap funds are different?
Both funds invest in large, mid and small caps. However, multi cap schemes are required to invest 25% of their funds in each of the market capitalisation categories, while flexi cap funds don’t have a fixed category-wise allocation mandate.
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