Are Flexi-Cap Funds Made For You?

We conducted research to determine if the flexi-cap fund is an appropriate category for the majority of investors. Read on to know what the results indicate

The Indian equity market and funds dedicated to them have done extremely well in the calendar year 2021. They have given stellar returns to investors. This is especially true for sectoral funds such as Information Technology (IT) and infrastructure funds, which were the show-stoppers of last year. These were followed by small-cap and mid-cap funds that too generated robust returns. Having said that, flexi-cap is one such category that was among the top 15 in terms of performance in the previous year. In 2021, on an average, flexi-cap funds generated return of roughly 32 per cent. 

The Securities and Exchange Board of India (SEBI) modified the definition of multi-cap funds, resulting in the creation of the flexi-cap category after mutual fund rationalisation. On September 11, 2020, SEBI published a circular requesting that all those multi-cap funds that wanted to remain multi-cap funds needed to deploy at least 25 per cent of their assets each to large-cap, mid-cap and small-cap stocks by February 2021. This was done to ensure that the funds lived up to their name. With this, mutual fund investors were unsure whether to stay with such funds and stock investors were surprised since such big selling and purchasing would cause a lot of volatility in the market.

However, following a debate and proposals from stakeholders, SEBI created a new category known as flexi-cap. The definition was set so that the multi-cap funds would now be free to allocate funds across market capitalisations. Is this old wine in a new bottle and still one of the most diversified equity funds? And can investors rely on it? In this article, we will look at how flexi-cap funds have done in terms of risk and return throughout the years. We have also gone one step further, comparing the performance of flexi-cap funds against that of multi-cap funds, large & mid-cap funds, and the portfolio of large-cap, mid-cap and small-cap funds.

Allocation of Assets The asset allocation of flexi-cap funds has always been large-cap-skewed, which is not the case with multi-cap funds. Flexi-cap funds have larger exposure to large-cap stocks. The following graphs give a glimpse of asset allocation at the end of December 2021.

"The essence of investment management is the management of risks, not the management of returns. Successful investing is about managing risk, not avoiding it."
– Benjamin Graham

When we examine the category average asset allocation of flexi-cap, multi-cap and large & mid-cap funds, we see that flexi-cap funds are large-cap prejudiced, with over 71 per cent allocated to large-cap equities. The sole distinction between multi-cap and large & mid-cap funds appears to be the allocation to small-cap stocks. Multi-cap funds devote an average of 18 per cent of their assets to small-cap investments, whilst large & mid-cap funds devote just 4 per cent.

Note: The asset allocation data is as on December 2021.

Performance
To understand the relevance of flexi-cap funds in one’s portfolio, we tried to compare the performance of this category against multi-cap funds, large & mid-cap funds, and an equal-weighted portfolio of large-cap, mid-cap and small-cap funds. For our study, we used Nifty 500 Total Returns Index (TRI) as a proxy for flexi-cap funds, the Nifty LargeMidCap 250 TRI for large & mid-cap funds, and the Nifty 500 Multi-Cap 50:25:25 TRI for multi-cap funds. Furthermore, we compared it to an equal weighted portfolio of large-cap, mid-cap and small-cap funds with Nifty 100 TRI, Nifty Mid-Cap 150 TRI, and Nifty Small-Cap 250 TRI serving as representatives.

When we look at the performance of various indices in terms of one-year rolling returns, the equal-weighted portfolio outperformed the other three indices most of the time followed by Nifty LargeMidCap 250 TRI. However, when we look at three-year and five-year rolling returns, the Nifty LargeMidCap 250 TRI outperform other indices.

When the one-year, three-year, and five-year median rolling returns of the indices in the study were examined, the Nifty LargeMidCap 250 TRI outperformed all other indices, followed by an equal-weighted portfolio. However, this is only one side of the coin. Before making any investing decisions, you should consider the fund’s risk.

Risk
Understanding the risk involved in mutual funds, or any other investment avenue for that matter, is critical. In terms of risk, we would look at risk metrics such as standard deviation, downside deviation and maximum drawdown. Furthermore, risk-adjusted return ratios such as the Sharpe and Sortino ratios would also be considered to make a proper judgement.

As we can see, the equal mix of large-cap, mid-cap and small-cap indices did admirably well in terms of returns, but when it comes to risk, it is the worst performer. Its highest drawdown is negative 47 per cent. However, among all of these indices, the Nifty Large MidCap 250 TRI performed the best, with one of the highest risk-adjusted return ratios and the lowest in terms of other risk metrics. However, in terms of risk, as assessed by standard deviation and downward deviation, all of the indices behaved similarly. The biggest difference can be seen in the maximum drawdown figures and risk-adjusted return ratios.

Conclusion

Benjamin Franklin’s adage “a penny saved is a penny earned” has a deeper significance and ramifications while investing. This is also true when it comes to investing in mutual funds. This is a trend in which individuals tend to focus on the return side of the coin while completely ignoring the risk side of the coin. However, the better you manage risk, the easier it will be to achieve your financial objectives. We conducted research to determine if the flexi-cap fund is an appropriate category for the majority of investors. According to our findings, large & mid-cap funds outperformed flexi-cap funds, multi-cap funds and an equal-weighted portfolio of large-cap, mid-cap and small-cap funds. Despite being overweight on large-cap stocks, flexi-cap funds just match the risk of large & mid-cap funds.

The chance of losing your wealth over a five-year period is quite low with large & mid-cap funds. According to our research, large & mid-cap index provided negative returns just once in 1,241 observations of five-year returns, and it was for a negative 0.1 per cent. The flexi-cap, on the other hand, provided negative returns three times in 1,241 observations, with a maximum loss of 1.1 per cent. However, for most investors, large & mid-cap funds with a time horizon of at least five years are preferable. That said, it is essential to have a well-balanced portfolio of equities and debt and for those with moderate to high-risk profiles considering large & mid-cap funds as their large-cap allocation.