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For a compact yet all-weather portfolio, multi-cap funds are a superior alternative to large-caps

Recently, I came across an interesting question from an investor. The questioner felt that there was a contradiction between two separate approaches to choosing equity mutual funds that have been reco

Recently, I came across an interesting question from an investor. The questioner felt that there was a contradiction between two separate approaches to choosing equity mutual funds that have been recommended on Value Research Online. One approach is that for long-term gains from equity funds, investors should choose to put most of their money in funds that invest in large-cap funds, along with some exposure to mid-cap and small-cap funds. The other approach is that one should invest in a multi-cap fund. These are funds where the fund manager can move investments between large-cap, mid-cap and small-cap funds as required by his perception of how the equity markets are going to behave.

A recommendation for the second approach implicitly rules out the first one. Sometimes, it explicitly states that one should not invest in a large-cap fund because it limits the fund manager to just one kind of investment, thus placing artificial limits on the portfolio. This is actually the same argument that is valid with regard to any specialised fund, whether sectoral or thematic, or indeed, capitalisation based. The underlying principle is that one should never invest in anything but a completely diversified fund. As the market twists and turns, your fund manager must have the freedom to move to invest in any sector, theme or size of company.

When you invest in a mutual fund, you are paying a fund manager to make investing decisions for you. It’s his or her job to figure what type of investment is best at the moment. Whether its large-cap or small-caps or infrastructure or technology--or all of them--which are the right areas to invest in, that’s part of the service that you are supposed to get when you invest in a mutual fund. However, when you get tempted by a fund that’s supposed to limit itself to a particular subset of the market, then you are pre-empting the fund manager and making an investment choice yourself. Without fail,, the time period over which a specific type of investment does well is a subset of the time period over which the entire market does well. This may not appear to be the case over a short timeframe but in the long run it is always true. At almost every specific point of time, it looks foolish to have invested in a completely diversified funds rather than a limited mandate one. However, it’s only when you take a long period into account, you realise that the identity of the type of fund that is doing well keeps changing in unpredictable ways.

It comes as a surprise to many investors to hear large-cap equity funds being described as having a limited mandate, which is something we normally say about sectoral funds. However, that’s the way it works. There are prolonged periods in the equity markets during which large cap investments do worse (or less well) than mid-cap or small-cap investments. The last few weeks have been such a phase and this has simply drawn attention to this fact. A fund that is limited to large cap investments can fall far behind during these high-growth phases of the markets. It can also miss out, by design, many good investments.

The apparent contradiction arises from the difference between a portfolio and a single fund. Till a few years ago, there weren’t too many flexible, multi-cap funds from which an investor could choose. The default way to achieve a balance was to invest separately in good large-cap, mid-cap and small-cap funds. However, things have changed now. Investors have a good choice of multi-cap funds with long track records. Staying invested in a flexible way no longer requires investors to invest in a combination of different types of funds.