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Is betting across market caps a wise investment decision? - Outside View by PersonalFN

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Is betting across market caps a wise investment decision?
May 5, 2011

The equity markets very often are a tantalising for many investors worldwide, as they provide opportunities to create wealth over the long-term. At every social gathering very often we come across individuals talking about the stock markets, and opportunities therein - be it stocks, sectors and market capitalisations (i.e. large caps, mid caps and small caps). And mind you everyone has their own view on them! For some investing in large caps construes to be more stable, while for some mid and small cap space seems to be an ocean of opportunity for wealth creation at an accelerated pace.

But in our opinion, it pays to be prudent and invest across market capitalisations as this helps you create wealth over the long-term and avail of the opportunities within each market cap segment (as well as sectors).

But how can one do that?

Well, there are two ways in which you can do that. First, you can either invest individually into a various well researched large cap funds (or large cap stocks), mid cap funds (or mid cap stocks) and small cap funds (or small cap stocks). Second, you can invest into the "multi-cap" category of mutual funds which will invest your hard earned savings into stocks across market cap segments.

Let's understand in little more detail the features of multi-cap funds, and how they function.

Multi-cap funds as mentioned earlier are not restricted to invest in a specific market cap segment - be it large caps or mid and small caps. They can spread their investments across market capitalisations with an objective of creating wealth for you investors (by delivering alpha returns). Hence, given that they have the capability of taking opportunities arising across market cap segments (i.e. large, mid and small caps) as well as sectors.

Moreover, they are not confined to one particular style of investing, which allows them to follow a value, growth or blend style of investing. While undertaking their stock picking activity too they can follow a bottom-up as well as a top-down approach of investing across capitalisations. Thus given that fund managers of multi-cap funds too actively engage in changing allocations across market capitalisations in an attempt to achieve alpha returns.

How Multi-cap Funds have fared?
Scheme Name 6-Mth (%) 1-Yr (%) 2-Yr (%) 3-Yr (%) 5-Yr (%) Since Inception (%) Std. Dev (%) Sharpe Ratio Portfolio Turnover Ratio (%) Expense Ratio (%)
Fidelity India Growth (G) -3.6 16.2 45.0 15.8 - 7.4 8.37 0.12 12.00 2.31
Morgan Stanley A.C.E (G) -8.8 8.7 49.1 14.4 - 14.9 9.59 0.10 133.00 2.33
HDFC Premier Multi-Cap (G) -7.1 11.7 49.1 14.1 12.2 19.7 9.66 0.10 21.20 2.24
Reliance Reg Savings-Equity (G) -9.3 6.7 43.8 12.4 21.3 21.6 10.21 0.09 96.00 2.00
Sundaram Equity Multiplier (G) -7.4 6.2 33.6 6.0 - 9.2 8.97 0.03 112.00 2.30
SBI Magnum Multicap (G) -10.2 0.4 30.0 3.5 5.2 11.1 9.09 0.01 61.00 2.26
L&T Multi-Cap (G) -11.2 3.2 31.8 2.7 2.1 10.7 10.57 0.02 129.00 2.50
BSE SENSEX -3.9 10.5 34.0 7.6 11.9 - 9.70 0.05 - -
BSE MIDCAP -14.2 2.4 44.4 3.5 6.1 - 12.29 0.04 - -
BSE SMALLCAP -17.6 -2.9 50.1 3.0 5.5 - 13.46 0.05 - -
S&P CNX 500 -7.0 7.9 34.9 7.0 10.4 - 10.13 0.05 - -
(NAV data is as on April 13, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period.
Risk-free rate is assumed to be 6.37%); *AUM as on March 31, 2010; (Source: ACE MF, PersonalFN Research)

So far multi-cap funds have been able to deliver appealing returns as revealed by the table above. On a 3-Yr return front, most multi-cap funds equity funds led by Fidelity India Growth Fund have created wealth for you investors. However, as evident from the table above those with resilient investment processes and systems have been able to deliver enticing returns without exposing their investors to very high risk (as revealed by the Standard Deviation), but at the same time generated high risk-adjusted returns (as revealed by the Sharpe Ratio). Moreover a noteworthy point is that, they have been able to do so without indulging in much portfolio churning.

Portfolio Characteristics and strategy:
Multi-cap funds generally own 40-50 stocks in their portfolio which are across market capitalisations, thus providing the fund manager flexibility and opportunity to move across market cap segments depending upon the market scenario under each segment. Hence for example, if the fund manager wants to undertake value style of investing when the equity markets enter a bear phase, he may then take stock bets in large caps or mid caps depending upon how the fund manager perceives value in them and how he defines "value investing".

But a good multi-cap fund will always attempt to frequently align the portfolio which suits market conditions across market capitalisations. However in an attempt to do so, if a fund manager fails identify the market conditions correctly and doesn't engage in frequent alignment of the fund's portfolio, then that may hamper the fund's performance, where one may witness returns faltering, risk going high and risk-adjusted returns turning abysmal. Moreover since some multi-cap funds also follow top-down approach (along with bottom-up approach) for stock picking, sector allocations too have to be taken care of, as quite often sectors go in and out of favour depending upon industry and economy related news emanating from the respective industry. Thus in this attempt of aligning portfolios (across market capitalisations and sectors) multi-cap funds can generally display a high portfolio churning (which may result in their expense ratio ballooning).

The verdict:
Well, such funds are appropriate if you are willing to take exposure across market capitalisations (i.e. large caps, mid caps and small caps). Moreover, as mentioned earlier it is prudent to have exposure across market capitalisations as it enables you to avail opportunities across market cap segments, in your objective of wealth creation. But while selecting a multi-cap fund always prefer a fund from a fund house which follows strong investment processes and systems as this will enable you to take exposure to good quality stocks (across market caps and sectors) and at the same time create wealth (through luring returns) without having exposed to high risk and high portfolio churning.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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