The Indian investor is spoilt for choice when it comes to mutual funds. There seems to be a fund to meet every investment need and risk profile.

One of the challenges that investors constantly face is to rebalance their portfolio according to market movements. If mid-cap stocks were the flavour in 2004 and 2005, large caps made a comeback after the market crash of May 2006.

Now, mid-caps have taken centre-stage once again. It is neither possible, nor advisable for investors to change their mutual fund portfolio to reflect current market trends since the investments have been made to suit their long-term financial planning needs. Then, is there a way out?

What are multi cap funds?

As the name suggests multi-cap funds look for investment opportunities across the spectrum of market capitalisation. Unlike a Franklin Blue Chip or a Sundaram Select Mid-cap, these schemes have the flexibility to invest in good propositions irrespective of the market capitalisation of the company. They seek to move into the segments of the market that are expected to do well in a particular period.

This gives them a number of advantages. First, since the fund manager is not hemmed in by a narrow mandate, he has greater choice. For example, the mid-cap segment is now an opportunity for funds that do not focus on large caps.

Second, since the fund invests across the market, there is better scope for diversification of stocks. However, there is a flip side too.

This strategy has a higher element of risk as funds can move to high-risk stocks.  Also, a higher number of stocks to choose from could result in greater portfolio turnover and, therefore, higher costs for the investor.

Finally, this strategy is dependent largely on the fund manager's ability to spot trends and opportunities; a strategy built around the fund manager can be more risky than a process driven one.

Performance

The Indian mutual fund industry saw a spate of multi-cap funds being launched in 2005: Franklin Templeton's Flexi Cap, HDFC Premier Multi Cap and SBI Magnum Multi Cap, to name a few. But have these funds been able to meet the defined role of multi-cap funds?

Returns from these funds over the last two years show that, on this score at least, they have not outperformed other diversified equity funds. Though on point-to-point basis multi-caps have underperformed the diversified equity funds, the one-year rolling returns, which removes period bias, show a better performance - returns are on par. (See: Scoreboard).

In the two years since inception, Franklin India Flexi Cap gave compound annual growth rate return of 38 per cent while HDFC Premier Multi Cap returned 33 per cent. Over a three-year period HSBC India Opportunities gave a 37.8 per cent return.

The USP of these funds is a strategy to exploit investment opportunities across market capitalisations as they arise. However, the fund managers have not been able to effectively utilise this mandate to significantly outperform diversified funds.

Despite being launched in early 2005, these funds chose to invest pre-dominantly in large-cap stocks, thereby missing the rally in the mid-caps that continued until the first quarter of 2006. They continued to be invested in large-cap stocks in 2006. But only some of these stocks have led the rally in the stockmarket after the May 2006 crash. So, funds that are not invested in them have not been able to gain much.

The 2.3 per cent return from SBI Magnum Multi Cap in the last one-year period is a reflection of the fund having a low exposure to large-cap stocks during the period. The past performance of these funds is almost similar to that of diversified equity funds, although the mandate was to outperform them. But, since these funds have not been around for too long, it may take them some time to hit their stride.

Flexibility

So, does this leave the investor's need for a flexible product unsatisfied? While schemes specifically designated as multi-cap funds may have not delivered on their promise as yet, there are funds in the diversified equity space that have retained the flexibility to invest across market segments.

Birla Sun Life Equity had, on an average, 40 per cent of its assets in the mid-cap segment during the upturn in this segment. This allocation reduced after mid-2006, and in line with market movements the fund increased its large-cap holdings.

The fund gave CAGR returns of 12.5 per cent in the one-year period and 43 per cent and 44 per cent in the three-year and five-year periods, respectively. Similarly, the DSP ML Equity has managed its portfolio composition to give annual returns of 40 per cent in the three-year and five-year horizons.

On a less flexible platform are schemes like Franklin India Prima Plus and HDFC Equity, which, despite a large-cap orientation, had on an average 25-30 per cent in mid-cap stocks during the rally in that segment and reduced the allocation when markets reallocated resources to large-caps.

While Franklin India Prima Plus gave returns of 37 per cent and 41 per cent over three-year and five-year periods, HDFC Equity gave returns of 38 per cent and 44 per cent over the same time frames.

What to do?

A multi-cap fund will ensure that an investor gains from tactical shifts in market focus without affecting his overall long-term portfolio strategy. It cannot, however, form the core of a portfolio. The role that an investor assigns to such a fund and the extent of holding will depend on his other investments and risk profile.

In selecting the schemes, you must ensure that the overlap in strategy and portfolio is minimised. This means that an investor whose portfolio is skewed towards large-cap-oriented funds should look for a flexible scheme - DSP ML Equity or Birla Sun Life Equity - that is willing to go overweight on mid-caps when that segment is doing well, and add a zing to the portfolio.

On the other hand, portfolios that are oriented towards mid-caps and have a higher risk profile may do well to add a conservative, flexible fund such as HDFC Equity or Franklin India Prima Plus to get greater large-cap presence in the portfolio.