Flexi-cap funds are one of the most popular categories in the Indian mutual fund landscape. They offer fund managers the flexibility to invest across all market capitalisations-large-cap, mid-cap, and small-cap-without any mandated limits.
The core strength of a Flexi Cap Fund is its dynamic asset reallocation ability, enabling it to chase growth in various sectors, thus making it an investment vehicle for all market cycles. This dynamic approach is governed by the manager's deep analysis of market conditions, valuation, and the economic cycle. In this blog, we will explore how asset allocation shifts occur in flexi-cap funds.
What are Flexi-cap Funds?
The fundamental principle of a Flexi Cap Fund is that there are no minimum or maximum exposure limits to any market segment. The fund manager has the flexibility of dynamic fund allocation to navigate through various economic cycles and changing market conditions.
- Large-cap stocks are the well-recognised, established giants that form the anchor of the portfolio for stability and steady returns during times of uncertainty.
- Mid-cap stocks strike an ideal balance between growth and stability.
- Small-cap stocks are capable of potential alpha returns in favourable market conditions but are generally high-risk, high-reward stocks from either new or fast-growing companies.
A fund manager's decision to shift between these segments is an active and strategic process, rooted in the fund manager's view on the economy and market valuation. For example, a few well-known flexi cap funds in the Indian mutual fund industry are the Parag Parikh Flexi Cap Fund, Franklin India Flexi Cap Fund, Bank of India Flexi Cap Fund, HDFC Flexi Cap Fund, and more.
The rationale for this shift in flexi cap funds lies mainly in the need for the protection of capital through the reduction of risk in an expensive segment and shifting capital to quality, established businesses that are trading at more reasonable valuations.
On the other hand, a major market correction is usually caused by an external shock and presents an attractive buying opportunity. During such times, Small-Cap and Mid-Cap stocks witness higher corrections than Large-Cap stocks, thereby becoming an attractive investment opportunity from the valuation point of view.
The fund manager, therefore, strategically shifts assets from Large-Cap holdings into these undervalued Mid- and Small-Cap stocks. This is called value buying, wherein fund managers make the most of the market correction by acquiring high-growth companies at huge discounts.
How the Market Cap Shift Works
These shifts are not accidental but rather calculated, based on two major factors: valuation and economic cycle.➤ Response to Valuation
The relative valuation of the market segments serves as the most direct signal in changing asset allocation for a Flexi Cap Fund manager. For example, when Small-cap stocks get highly overvalued, reflected by a high Price to Earnings (P/E) after an extended rally, the fund manager would transfer capital from the overvalued Small-Cap segment into Large-Cap stocks.The rationale for this shift in flexi cap funds lies mainly in the need for the protection of capital through the reduction of risk in an expensive segment and shifting capital to quality, established businesses that are trading at more reasonable valuations.
On the other hand, a major market correction is usually caused by an external shock and presents an attractive buying opportunity. During such times, Small-Cap and Mid-Cap stocks witness higher corrections than Large-Cap stocks, thereby becoming an attractive investment opportunity from the valuation point of view.
The fund manager, therefore, strategically shifts assets from Large-Cap holdings into these undervalued Mid- and Small-Cap stocks. This is called value buying, wherein fund managers make the most of the market correction by acquiring high-growth companies at huge discounts.
➤ Timing Investments with the Economic Cycle
Different segments of the market do well during different phases of the economic cycle. During the Early Phase/Recovery Phase, when the economy is accelerating, the managers raise the portfolio allocation to Mid-cap and Small-cap stocks. Smaller firms, because of higher operating leverage, tend to benefit more quickly from economic tailwinds as their earnings grow faster. This phase is known as "Growth Hunting".During the Expansion or Peak Phase, when the market enters its maturation phase of its cycle and valuations start turning stretched, the growth rates start slowing down. Managers then start consolidating the portfolio into stable Large-cap stocks and focus on sectors that are defensive or market leaders. The focus now shifts to "Quality and Stability."
During the Contraction or Recession Phase, when market sentiments are negative, the fund managers increase exposure to the safe haven in equities and may also raise cash/debt funds temporarily to protect capital, waiting patiently for the turnaround of the cycle. This is the "Capital Preservation" phase.
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