The first lesson anyone teaches you about investing is asset allocation and diversification. While asset allocation is a method of diversification, most investors often see them as the same thing. Yes, it is true, both are favorable ways of reducing risk and optimizing the return potential of an investment portfolio. However, in practice, they are different. While asset allocation is a way to diversify your portfolio by investing in asset classes, diversification is a broader concept and refers to investing in different sub-segments within the same asset class. This diversification is necessary within the asset class in a portfolio because the markets are dynamic.
The stock markets today are experiencing that kind of volatility which is bound to haunt the investors. The ongoing pandemic, inflation concerns, rising US Treasury yields, volatile commodity prices, provide more than one reason for investors to be wary of investments. However, this uncertainty is not without its wealth-creation opportunities. While some companies thrive under such economic conditions, others thrive.
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Multicap funds are inherently diversified as they invest in stocks of different market capitalizations, i.e. large cap, midcap and small cap. What makes this category stand out in its strategy is that it is mandatory to invest a minimum of 25% in each of the 3 caps, the remaining 25% is flexible to invest in all three. Investing in multicap funds helps you get exposure to all segments of the market, irrespective of the market cycle.
This means that in any market environment, be it a bullish or bearish market, the stability of large caps and high growth potential of mid and small caps helps in balancing the portfolio. Also, this way, your downside risk in a falling market can be limited.
The definitions of large, mid and small cap stocks are reviewed on a half-yearly basis by the Association of Mutual Funds in India (AMFI), the mutual fund industry body. Broadly speaking, the top 100 listed stocks make up the large cap stocks, midcap stocks are the ones that fall in the 101st and 250th positions and since the 251st stock, the small cap universe begins. The large cap portion of the fund provides stability with comparatively low downside risk, mid cap provides a balance of growth and stability, and the small cap portion promotes the performance of the portfolio over the long term.
An investor opting for a multicap fund gets exposure to the entire market through a single fund. This is particularly attractive to those looking for consolidated exposure to the equity market through a single financial solution, as opposed to investing in funds with a focused strategy.
Also, in any given market cycle, the performance or return potential of each market cap will vary. Furthermore, even within each market cap, the performance of a stock may vary based on the growth prospects of the individual company.
Multicap funds can also be a suitable investment option for young and new to the market investors who have risk appetite and a long-term investment horizon, but are unsure about which market cap to choose. Multicap funds also make a good case for long-term investors who want to build wealth and potentially meet their financial goals with a better risk-return trade-off. To have a fair taste of the market, these investors should have an ideal investment horizon of around five years.
Overall, multicap funds aim to provide superior risk-reward trade-offs by limiting upside risk, while creating reasonable upside opportunities.
DP Singh is the Chief Business Officer at SBI Mutual Fund.
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