Is the FoF investment strategy a good approach to multi cap investing?

The market is on a bull run and the indices are touching new levels every other day. As the mid and small caps are yet to play out as much as the large-cap stocks, multi-cap investing makes more sense in the current times. Investors are happy yet confused about a lot of aspects in the market. Here are a few pertinent questions that are bothering the investors:

  • Whether to invest in actively managed funds and expect the fund manager to outperform, or invest in index funds / ETFs since over the last couple of years, passive funds have done better;
  • Of the various categories of stocks available, whether to go for large cap or mid cap or small cap. And what should be the ratio of allocation;
  • Which funds to choose for investments. There has been divergence in performance of multi-cap funds, hence concentrated bets may not lead to optimum results.

These topics can be the subject of lengthy debates, but the purpose of this article is not to initiate that debate. The new approach is to do the allocation between large, mid and small cap stocks based on collective market wisdom, since it is difficult for one fund to get it right consistently. It combines active and passive management in the same fund, does the allocation as per a broad benchmark, and does away with the requirement to pick Fund A over Fund B.

Market-cap based allocation
Let us start with Mirae Asset Equity Allocator Fund of Fund (FoF). This is an FoF that invests in equity ETFs i.e. rather than you having to buy a basket of ETFs, when you buy units of this fund, you are getting exposure to the underlying ETFs. This fund invests in ETFs based on Nifty 50, Nifty Next50 and Nifty Midcap150. This is largely passive investment, as the underlying are ETFs. For allocation to the segments of stocks, this fund broadly follows the underlying market-cap based weightage. That is, as per overall market cap, if the market cap of large cap segment is X% and that of midcap is Y%, the fund will follow that.

In other words, instead of debating what should be the allocation, the “message” given by the market, which represents the collective wisdom of all market participants, will be followed. The ratio indicated by the market cap of the various segments is the gist of that collective wisdom. There is a bit of active fund management as well, in terms of allocation. As an example, between Nifty 50, Nifty Next50 and Nifty Midcap150, if Next50 is at a discount based on forward P/E compared to historical levels, then a little higher allocation will be made to Next50 ETF.

Fund-industry-view based allocation
Now there is another idea on active-passive management and segment allocation. Nippon India Mutual Fund has come out with an NFO called Nippon Passive Flexicap FoF. This FoF will invest in ETFs and Index Funds i.e. Nifty 100 ETF, Midcap 150 ETF and Small-cap 250 Index Fund. The thesis here is that the category among large, mid and small cap delivering superior returns varies every year. Staying invested across segments over a long period of time helps, but asset allocation is also important. For allocation, this fund goes with the collective wisdom of fund managers. While the market does give a message in terms of weightage, fund managers are expected to read what is coming. Historical data suggests that allocation to ETFs as per collective fund-manager wisdom has outperformed most funds in the multi-cap category, with a lower volatility. Moreover, taking the message from the collective wisdom of fund managers diversifies the individual-manager-call risk. This means that this FoF will follow the average allocation of multi-cap funds (now changing over to flexi-cap) to large, mid and small cap segments.

What is the advantage of this new approach for investors?

  • You don’t have to rack your brains about which ETF to buy, what proportion, having a trading account with a broker, liquidity when you want to sell, etc. It is all done in the fund.
  • Benefit from a relatively lower expense ratio in ETFs / Index Funds.

The popularity of allocation to multiple categories is borne by the fact that in the industry, the second-highest AUM is in multi-cap funds (now changing over to flexi-cap), next only to large cap. The confusion following the SEBI mandate on minimum allocation to small cap stocks in multi-cap funds shows that investors and fund managers want flexibility in allocation. These ETF / Index fund based FoFs offer flexibility and diversify the risks of calls taken by one fund manager. Given the advantages, you may do a SIP in these ideas to build your core portfolio.

(The writer is a corporate trainer -debt markets, and an author.)