Strategy to balance high valuations in Mid & small caps- Go for multi-cap funds to reduce risks

Strategy to balance high valuations in Mid & small caps: Go for multi-cap funds to reduce risks

Given that the valuations of small-caps and mid-caps are elevated, investors should look at multi-cap funds to diversify across market segments and ensure some systemic risk is mitigated, say experts. The investment mandate for multi-cap funds warrants that a minimum of 25% be invested in each of the three market cap segments, irrespective of market conditions, to generate optimal returns.

Valuations of mid-cap and small-cap stocks are trading at 26 times (x) the price-to-earnings (PE) ratio based on FY24 earnings as against 21x PE ratio of benchmark Nifty. In such a scenario, multi-cap funds offer a balanced option for retail investors if they are willing to invest for three to five years.

Similarly, Devender Singhal, executive vice president and fund manager, Kotak Mahindra AMC, says multi-cap funds often provide a more balanced and diversified option to retail investors compared to mid-cap and small-cap funds. “When the valuations of mid-cap and small-cap stocks in general are elevated, multi-cap funds provide a balanced option to invest for long-term growth,” he says.

Mandatory allocations in multi-cap funds offer investors the clarity on the minimum market-cap exposure to each segment. However, this also restricts the fund manager’s ability to go relatively underweight on the market cap segment irrespective of their view on the broader segment. In flexi-cap funds, the fund manager has the flexibility to determine the allocation based on market conditions.

Risk tolerance

Investors prefer multi-cap funds because they provide the stability and low volatility of large- cap stocks and higher returns of mid-caps and small-caps. The funds are actively managed and if fund managers spot an investment opportunity in mid-caps or smallcaps, the allocation towards them rises. This approach makes the funds a high-risk high-return investment proposition.

Soumya Sarkar, co-founder, Wealth Redefine, says since multi-cap funds allocate 25% to large-cap, 25% to mid-cap, and 25% to small-cap stocks at any given time, there is a significant portion invested in the mid and small-cap categories. “This diversification leads to fluctuations and, consequently, higher risks. When considering investments in multi-cap funds, investors should prioritise a robust risk tolerance and a substantial time horizon, ideally ranging from four to five years.”

Should you invest?

As multi-cap funds invest across mid and small-cap stocks, there could be volatility in the near-term. Nirav Karkera, head, Research, Fisdom, says investors must evaluate the fund manager’s ability to mitigate risks associated with broader cyclicality. “This can be assessed by evaluating the fund management team’s portfolio decisions and risk-adjusted performance of the fund during extreme turns in broader markets as well as specific market-cap segments,” he says.

Considering multi-cap funds are reasonably diversified across market-cap segments, funds in the category can be expected to deliver optimal returns through a couple of market cycles spanning through five years or so. Typically, during a bull market multi-cap funds perform well as mid-cap and small-cap stocks soar higher than large-cap stocks.

The decision to invest in a multi-cap fund should be based on the investor’s risk profile, financial goals and investment horizon. “Those investing in multi-cap funds should have an ideal horizon of three to five years considering the fact that a minimum total of 50% is invested across mid- and small-cap stocks,” says Subramanian.