Mutual Fund

Multi-cap reset! Know your options.

Change is the only constant in life, Ones ability to adapt to those changes will determine your success.” – Benjamin Franklin

Recent circular by SEBI [Link] issued on Sep 11, 2020 about the suggested change in the asset allocation of Multi-Cap funds has created a range of questions in the investors mind. The news article suggesting that the INR 40,000 cr is expected to move from Large cap segment to Small & Mid cap category [Link]. Such articles have created two branches of thoughts, first stimulating the worry that the multi-cap funds will become more volatile with increased exposure in Mid & Small cap stocks & Second triggering the greed that extra money inflow in Mid & Small cap stocks will reflect as improved returns in those stocks. I have lost the count of WhatsApp forwards received in last 2 days on this topic here is my assessment.

What has changed?

As per 2017 rationalization of Mutual fund schemes, Multi cap funds were classified to have a minimum investment in equity & equity related instruments of 65% of total assets. An open ended equity scheme investing across large cap, mid cap, small cap stocks. So in theory, the multi-cap fund manager has the largest buffet of stocks to pick and select from vs just any other market cap specific mutual fund category e.g. Large, mid or small cap. The new circular has created further changes in definition to mandate that each category of stocks Large, Mid & Small should have minimum 25% of allocation and overall 75% allocation should be in equity/ equity related instruments.

This change has taken away the ability of Mutual fund manager to pick & chose the stocks they like and allocate the money as per their choice. Most Multi-cap funds moved the allocation between Large, Mid & Small caps based on their understanding of business cycles for e.g. Currently most of the Multi-caps have allocated 65-80% of their portfolio to Large cap stocks.

What is the impact of this change?

In my opinion, market regulators want to increase the depth of the Indian stock market. I have mentioned it earlier, That 75% of market free float is in Nifty 100 companies while 12-15% in Nifty Mid cap 150 companies and single digit for small cap companies. Multi-cap mutual funds have the second highest AUM after large cap funds of INR 1,46,000 Cr [~USD 20 Bn] moving 25% of this AUM towards Mid & Small caps would definitely increase the prices of stock, liquidity and may be volatility.

Just to put things in perspective Total Market cap of Nifty Small Cap 250 stocks is INR 975,000Cr. Since most of these firms are promoter controlled and if conservatively we assume that 50% of this market cap is not available for churn then we are sending 27,000 cr money to add in the current market cap of 487,000Cr. This itself will translate in a gain of 5.5%.

Will the change happen in Multi-cap funds?

The circular by SEBI is a new guideline and would trigger a second level thought among fund managers & AMCs. If they believe that the current changes will be detrimental to the investors of their funds, the alternate options will be explored.

  1. Popular Multi cap funds like Parag Parikh Long Term Equity or Motilal Oswal Multicap 35 own less than 30 stocks and can be classified as focused funds. hence no change in asset allocation required.
  2. Funds which have 65-25-10 kind of allocation will find it easier to merged or classified as Large & Midcap fund rather than selling large caps & buying Mid/Small cap in large quantities.
  3. They can re-appeal to SEBI and request to modify the mandate from 25% each to more amicable split like 30-25-20

What should the investors do?

The speculation of large money moving to small caps or Mid caps can benefit the investors of this segment in short run but once the sense prevails the net gains will be negligible. Though some stock specific rallies might occur still for an average investor of mutual funds, no impact. Also regarding the volatility, In short run Multi-cap funds might witness the higher volatility though over a long term the impact will be minimal because once the required allocation in each category is achieved the churn in portfolios will reduce. Therefore, you do not worry a lot about this change & stay on course of your long term investment plan. Multi cap funds continue to be the category of choice to build your core portfolio.

To know our picks in the Multi-cap fund category read Category Review: Multi cap funds.

Investment Objectives & Advice

Efficient Frontier & Asset Allocation!

Couple of weeks back, i wrote about how do i select a fund for my portfolio. That has got quite a few review/ feedback, though few people also requested to share my approach on asset allocation. Today I am trying to put together my thought process, The real process is more or less meet these steps in principal for long term goals (5yrs & beyond). You might find this tedious but this is typically a once in few years exercise and If you find it tedious than stick with typical simplified thumb rules (I will summarize it in the end).

I typically segregate my portfolio in two sections, first which holds risky assets like equity & gold and second which has debt investments.

Step 1: The selection of equity funds was covered in detail in the last article (Please read: Link). I analyse the list of potential funds with there risk & return profile and then pick the fund which has a better return per unit of risk. This process can also be called as formation of Efficient Frontier. This is the line of selected funds in a manner that each fund has the best return for the same unit of risk. The funds which are not on the Efficient Frontier like ICICI Pru Bluechip or SBI Large & Mid cap etc are not considered. Based on my risk profile, I pick one fund from the funds on this frontier line.

Efficient Frontier

Step 2: There is an advantage of adding gold with equity funds which does reduces the volatility of the portfolio given the -ve correlation between gold and equity.  This was reflected in the earlier articles Gold: to buy or not to buy! & Modern Portfolio Theory I personally like to keep (10% – 20%) of risky asset portfolio in gold depending on the valuation cycle of equities. You can see from the below chart that portfolio 3 outperforms most of the time with lowest risk among portfolios. I personally prefer the Portfolio 2 which has similar return profile but slightly higher risk. The main reason to do so is that a good multi-cap fund mostly will have 60-30-10 split between Large cap, Mid-cap and Small cap. Instead of me looking for 3 different funds.

Portfolio 2 = Gold 10%, Large cap 54%, Midcap 27% and Small Cap 9%

Gold & Equity

Step 3: The last step is to decide the split between the risky assets and risk free assets. Risk free assets are your fixed deposits, EPF, PPF etc where the returns are fixed and not highly volatile. Debt funds does carry various risks like counter party risk, interest rate risk etc. (Read: How to build your debt portfolio.) The mix of debt investments is to reduce risk in your investments. Let’s see the possible range of returns i expect at the various portfolio mix.

Portfolio Returns_V1

So even if you are defensive investor, you should keep at least 10% investment in Eq+Gold and if you are a super aggressive investor, still i would suggest to keep 20% of your investments in the Debt instruments. I personally hop between three asset allocations 80% Debt/ 50% debt or 30% debt and rest in equity + gold based on Valuation Index. I have been in the 80-20 split for last 2 years and now moving towards 50-50 split, The last 10yrs CAGR of the portfolio is still >10% including the double digit returns in FY 19-20 even after the recent drop in equity markets.

Now, I can understand that doing all these things together can be too complicated for a simple investor. What is the simplified approach? A portfolio like below is widely suggested and it has its merit of being moderate in approach as well as can be suggested to a wider population. Follow a 60 : 40 Portfolio and keep re-balancing it half yearly, you will outperform most of the portfolios.

Asset Allocation

Please note that most of these analysis are on the past returns/ historical data so there is no guarantee of similar return profile in future. As i mentioned, I personally follow Dynamic Asset allocation mostly for the risk management and engagement in managing my portfolio. let me know if this was helpful, looking forward to your comments/ feedback. 

Happy Investing!