Wealth creation in the markets requires much more than mere good fortune. A combination of experience, detailed examination of facts and a disciplined investing approach helps build a portfolio of investments that give you stable returns.
Unfortunately, not everyone is equipped with the expertise needed to build such a portfolio. This is true for most professionals who do not belong to financial markets but want to invest in the markets and gain from it. For such people—who are large in number—investment in mutual funds is a good alternative.
In a mutual fund, a fund manager selects and builds a portfolio of good businesses for the investors in a scheme. But, there are hundreds of such mutual fund schemes spread across fund houses. Every fund house offers many schemes with a distinct investment objective. But understanding and comparing each one is an uphill task. To give you some perspective, AMFI (Association of Mutual funds of India) data puts the average assets under management by the Indian mutual fund industry at Rs 36 trillion in August 2021. So, how does an average investor decide which scheme to invest in?
To address this issue, the Securities & Exchange Board of India (SEBI)—the capital market regulator- released a framework to categorise mutual fund schemes in October 2017. This norm made an apple-to-apple comparison possible among funds belonging to a particular category. Among the categories SEBI proposed were focused equity funds and multi-cap funds. Read on to understand how these two categories of schemes differ from each other:
What is a focused equity fund?
Focused equity funds invest in a compact portfolio of maximum thirty stocks. Such a scheme is mandated by SEBI to invest minimum sixty five percent of its money in stocks.
What is a multi-cap equity fund?
A multi-cap equity fund, must by SEBI’s definition invest across large-cap, mid-cap and small-cap companies. However, most fund houses had been employing a ‘go anywhere’ strategy in multi-cap funds. This led to a situation where most multi-cap funds invested primarily in large-cap stocks. This, in the view of the regulator, was not a true multi-cap portfolio.
Hence, in September 2020, SEBI made it mandatory for fund houses to invest minimum twenty five percent each in large, mid and small cap stocks while managing multi-cap funds. Thus, multi-cap equity funds in their current avatar invest in stocks of companies of all sizes.
Though the fund manager invests twenty five percent each in large, mid and small cap stocks – which covers seventy five percent of the assets in these schemes, they do have the discretion to decide how to allocate the remaining twenty five percent capital.
Since focused equity funds can also invest in stocks of companies of all sizes--large, mid and small cap stocks, many think they are just like a multi-cap fund. But there are a few important differences between the two.
Multi-cap and Focused Equity Funds: How do they differ?
- Portfolio concentration
Focused equity funds are offered to investors as a bouquet of high conviction investment ideas of a fund manager. Since there are only thirty stocks, the money allocated to each stock is higher in percentage terms as compared to that in a multi-cap equity fund. If a fund manager gets the call right, then he makes very good money. But if it does not play out as envisaged, then the performance of the scheme may suffer.
Comparatively, multi-cap equity funds typically hold anywhere between fifty and eighty stocks and run a diversified portfolio.
- Market cap bias and relative risks
A multi-cap equity fund, at any moment of time, should mandatorily allocate twenty five percent funds to small-cap stocks. This segment of stocks is perceived to be inherently volatile and often suffer in a market downturn. Thus, while small cap allocation could be rewarding in good times; in times of stress, the same could act as a drag on the fund performance.
Focused equity funds have no such restrictions. Fund managers can switch from one stock to another freely as long as they hold up to thirty stocks in the portfolio of the scheme. In good times, a fund manager can pick some small-sized high-growth companies and make money out of it. In the not-so-good times, the fund manager may stick instead to select large-cap companies.
- Sector allocation
Neither multi-cap nor focused equity funds are mandated to allocate funds to certain sectors. There is no mandate that a fund needs to have an exposure to a certain number of sectors. However, given the portfolio’s construct, multi-cap equity funds with relatively more number of stocks, generally see allocation to more sectors than that observed in focused equity funds.
- Market movements
Stock markets trend in three ways – up, down and sideways. Fund managers are obviously put to the test in a down market or a sideways market where they have to pick stocks of companies that would make money in tough times. However, an upward trending market, too, makes the job of a fund manager even more challenging.
Sometimes a bull-market is polarised – in which only a few stocks keep moving up, while the rest of the market languishes. In some cases, the entire market moves up. The broad-based rally seen since June 2020 in the benchmark indices is a case in point. Fund managers have to be able to identify the nature of rally early in uptrend and position their equity portfolios such that it outperforms both the benchmark indices and other competing funds.
Multi-cap equity funds typically do well in a broad based market rally. Focused equity funds can do better than multi-cap equity funds, if a fund manager senses a polarised market and bets big on select stocks in the uptrend.
- Size of the fund
As an equity fund does well, more investors would want to invest in that scheme. Naturally, the assets of that fund inflate. A fund manager, then, has to work harder to maintain the performance, and, at the same time, ensure liquidity. As the size of a fund grows, typically beyond Rs 10,000 crore, managing a focused fund can be a challenge in the Indian market as the fund manager has to invest the money in only thirty stocks. Often, with a large corpus and restrictions on the number of stocks in the portfolio, a fund manager might be compelled to invest in large-cap stocks – which may not be the best investment picks. Beyond a point, this tight-rope walk could hit the performance of a focused equity fund.
The Fund manager of a multi-cap fund, however, does not face this issue. A multi-cap fund’s manager can add an extra stock to his or her portfolio to take care of both additional money and liquidity required and the scheme’s performance may not be impacted.
Fundamentally, investors should be aware that a fund manager’s expertise is key to the performance of focused equity funds. Comparatively, a multi-cap fund is considered low risk as it offers a diversified portfolio.
Thus, while, both, a focused fund and a multi-cap fund could deliver good returns, do consider your tenure of investment, your investment goals and risk appetite before you choose which fund to invest in.