The Mutual Fund Show: Are Flexi-Cap Funds Better Than Large-Cap Schemes?
Flexi-cap funds allow allocation across large, mid and small caps. But are these any better than large-cap schemes?
Flexi-cap funds allow allocation across large, mid and small caps. But are these any better than large-cap schemes?
The entire industry operates flexi-cap funds as a "pseudo large cap", Aashish Somaiyaa, chief executive officer of White Oak Capital Management, told BQ Prime's Niraj Shah.
"It's been happening since 2018 when the categorisation happened. I have been tracking these funds extremely closely since then, and you would see that these funds have 70-80% large caps and a very small percentage of mid cap and small cap allocation."
According to Kirtan Shah, founder and chief executive officer at Credence Wealth Advisors, in terms of risk, an equal-weight portfolio has a slightly higher standard deviation than a flexi-cap, but on a rolling return basis, the equal-weight performance is superior to a flexi-cap.
But flexi-cap can beat large-cap returns, he said. "Flexi today...is able to bring in the same kind of risk but has been able to outsmart large-cap returns by a stiff margin, looking at only the last three years since the categorisation."
For investors looking for alpha returns with consistency, it's important to have a good mix of large, small and mid caps, which is what flexi-cap funds also do, Somaiyaa said. "One needs to look for a good information ratio and hence, good consistency of alpha–not just high alpha–and then participate in this whole winner rotates kind of game."
Shah's recommendations include the Parag Parikh Flexi Cap Fund and SBI Focused Equity Fund as both the funds are well-managed. The two products "have been outperforming consistently", he said.
"I am not talking about a point-to-point analysis, but about a rolling analysis for at least seven years."
Watch the full conversation here:
Edited excerpts from the interview:
Aashish, it's an interesting time to launch a flexi-cap fund. Do you think the market conditions support that? Why did you choose this time and this offering?
Aashish Somaiyaa: I am afraid the credit for the timing must definitely go to the regulatory processing. I don't think we can time this at all frankly speaking, because we completed the acquisition of Yes Bank’s asset management company somewhere in November 2021, and after that we started filing for our products. There's an approval process and that's how we hit the market somewhere in July 2022.
In hindsight, it does appear as good a time or maybe better than some of the other timings, as far as launching a new venture and hence, launching a maiden fund. It’s an opportune time from that perspective.
I know your question is specific to flexi-cap as a fund or as a category. The last five to six years has been quite a roller coaster because when we say flexi-cap, obviously, it means that we are talking about investing across market capitalisation.
From 2015-16 till 2018, small and mid cap did very well; 2018 to 2020 small and mid cap did very badly; from 2020-2021 small and mid cap again did very well; and then from the end of 2021 till date, small and mid cap seems to be lagging.
So, at White Oak, our belief is that given the kind of changes to macro parameters–and those macro parameters hence put caps in and out of favour depending on the macroeconomic conditions and the market conditions–it's very difficult to time which market cap you should be in.
Our belief is that we should run the fund where we are about 30-45% in small and mid cap at all points in time, and never really swing totally in favour of large cap or totally in favour of small caps.
Considering the small and mid caps have been lagging large caps by quite a margin in the last nine months. From that perspective, it's a great time to be invested in any fund which has a substantial small and mid cap.
Our industry obviously confuses the matter with having something called Multi-cap and then something called flexi-cap. But at White Oak, there's no flexi-cap, multi-cap–there's only one fund which will have anywhere from 30-50% in small and mid caps.
Is that at odds with the industry? Retail investors would be thinking what is the USP that this new fund offering brings to the table over the multitude of others already there in the market.
Aashish Somaiyaa: Whatever in the industry today is called flexi-cap, till 2-3 years back, it was originally multi-cap. There was a point in time from 2018 to 2020 when small and mid cap hit a big slump, and all the multi- cap funds ended up becoming something like 80-90% in large cap, so then obviously the regulator was right in pointing out that your multi-cap funds are looking like large caps and are not looking like multi-cap.
So, multi-cap has to be minimum 25% small cap, minimum 25% mid cap–basically, if you call it multi-cap, it has to be all caps.
The history is that currently what the industry is running as flexi-cap was originally anyway supposed to be multi-cap.
The only thing White Oak is doing is to launch something which was genuinely what multi-cap was supposed to be and not getting confused with nomenclatures, because even if we call it multi-cap, then again, we will have minimum 25% small cap and minimum 25% mid cap. We don't want all those limitations.
We want a fund which runs like what multi-cap used to run, but don't want to get caught up with the minimum level and the nomenclature and those complications.
That's the first thing. The second thing is how is it different.
Of course, there is a stock-picking process and the investment philosophy, but I just bring out the two or three differences.
Usually, when a new AMC comes, you have no idea what is the portfolio performance, track record, nothing at all. In White Oak’s case, it's a bit different because while our domestic mutual fund is coming only now, as a group and as a house, we already manage about $5 billion. Within the group, we are one of the larger investment managers for foreign portfolio investors investing in India.
We already have a PMS (Portfolio Management Service) and AIF (Alternative Investment Fund) which we have been running for three years. So, in the last five years, White Oak has been running global funds investing in India.
Within the group, within the investment team–and Prashant who is our founder and ex-CIO of Goldman Sachs–there is a track record. There is a 32-member investment team, which is very well-resourced, and among the best resource teams in the industry.
The other important thing is that generally everything to do with fund management is made out to be about stock-picking. Where White Oak is significantly different is that we focus a lot on portfolio construction, because the portfolio is not a list of stocks.
If you see in the industry, winners rotate. Why do winners rotate because the best of funds and the best of stock picks goes out of gear when the macros change. That's why winners keep rotating. So, portfolio construction is very important and at White Oak, we focus a lot on portfolio construction such that we are able to generate outperformance over BSE 500 as consistently as possible.
In short, these are a few things that one might want to really look at.
Kirtan, tell us your view on the timing for flexi-cap fund investing. What are you telling your clients when they seek your opinion about where to invest within the equity landscape?
Kirtan Shah: The entire industry operates flexi-cap fund as a pseudo large cap. It's been happening since 2018 when the categorisation happened. I have been tracking these funds extremely closely since then, and you would see that these funds have 70-80% large caps and a very small percentage of mid cap and small cap allocation is there.
It is ideally not what you really want a flexi-cap to do. By the name flexi, you really want to move around with where the macros are moving or probably take larger bets on what will really work in favour of the investors and in terms of investing. But unfortunately, the space has not been able to do that on the industry average standpoint.
Since 2018, those times are gone where we would say if you don't understand what and where to put money, put that in flexi so that the fund manager who understands it better will be able to do a better job than you and I will be.
But that's not what the industry is giving back because if you look at the industry average, it is a pseudo large cap. Since 2018, what has started happening is that everybody that I know–often in my ecosystem–have started allocating money to large, mid, and small separately, instead of saying do flexi-cap and let the fund manager manage.
Even if you look at some very basic data points–we can't go back before 2018 because of the categorisation and it will not be an apple-to-apple comparison–but if you look at the combination of equal weighted large, mid, and small fund, this combination has done much better than what the current flexi market offers.
In terms of risk, you compare both standard deviations, the equal weight portfolio has a slightly higher standard deviation than probably a flexi-cap, but on the rolling return basis, the equal weight performance is far superior to that of flexi.
Then the point comes why do you do flexi in the way it is part of the industry right now. To share some data on what even Aashish pointed out, if you look at the last three years of industry category average of large cap and flexi, you will understand that the standard deviation of large cap and flexi is almost the same–at 21.3, 21.4.
But you will see a serious 1.5% alpha that flexi has been able to generate versus a large cap.
Flexi today, if you look at risk return, is able to bring in the same kind of risk but has been able to outsmart large-cap returns by a stiff margin, looking at only the last three years since the categorisation.
While equal weight makes a lot of sense because of flexi not operating the way it should be, why don't you replace the large-cap category by the flexi? So, you do flexi as a large cap and then you allocate money to mid cap and small cap. I think that combination is far superior than a standalone flexi on a risk return basis.
What Aashish is trying to say is that's what they will try and tackle which is to create a pure play of flexi-cap fund in the essence of a multi-cap fund having 25% and 25% separately. Aashish, what's the sense that you have when you think of building a portfolio in a flexi-cap fund, which is 25% mid cap, 25% small cap and 50% large cap? Is this aimed at generating a far higher alpha over normalised returns? What is the internal target of what you would want to do via this fund?
Aashish Somaiyaa: I will clarify one thing. We are basically going to have anywhere between 30-50% in small and mid cap. And since we are calling the fund flexi-cap, we will not have to necessarily, compulsorily show 25%-25%.
There are two things that I wanted to share: one is that clearly small and mid cap over long periods of time–and by long periods we mean not like 10-20 years, but in any three-year, five-year time frame with the cycle–can afford more alpha generation as compared to large caps.
Second is precisely that is why within the White Oak Group, we have a very large research team. Our investment universe is everything over $150 million. So, we give out Rs 1,000-Rs 1,200 crore plus and about 750 odd companies fall within our investment universe. All of them are mapped to this large battery of analysts that we have. So, the target clearly is to beat BSE 500 Total Return Index by as high a margin as possible.
But, equally true, one needs to look for a good information ratio and hence, good consistency of alpha–not just high alpha–and then participating in this whole winner rotates kind of game. So, you want high alpha, but you want consistency. From that perspective, having a good mix of large, mid and small caps is the right thing to do.
If one actually tries to do what Kirtan was alluding to–saying at the right time, I will be into large caps and then at the right time, I will sell down those positions and I will bank on small and mid-cap. I think there's no just-in-time investing. That's not going to be possible.
The best is to have a reasonable allocation at all points in time and then just make relative value switches if you find it relevant, but not to do something really drastic or dramatic like making some market cap zero and then overloading something else.
And this is a strategy that you would pursue? It's not a timing-based strategy. It's something that you would have done, irrespective?
Aashish Somaiyaa: Absolutely.
So, that's the view from Aashish Somaiyaa of White Oak Capital about their maiden offering, which is flexi-cap. Kirtan said as per his analysis, if you want to get into a large-cap fund, instead get into a Flexi Cap fund because it gives better returns with the same kind of risk.
I have asked a couple of advisors and their standard view has been that unless the NFO brings something special to the table, they would want the fund to show performance for 3-6 months and then get into it. What's your sense about this NFO from the White Oak Capital stable, considering that I heard you say most of the flexi-cap offerings, as of now, are not true blue flexi-cap funds?
Kirtan Shah: My biggest problem with the flexi-cap category is what I spelt out. If White Oak is able to address this space, then a flexi-cap fund will definitely stand out.
This larger philosophy of what are they going to do and where are they going to allocate, that is not going to give anybody confidence in terms of fund performance.
At the end of the day, you might stand out drastically with respect to the industry doing and you might take the right step. That's a brilliant positive but you will still need some performance history to go back to, to kind of try and understand whether this is the right kind of fund that you really want to invest in.
Because if you currently look at the offerings, there are 20 plus funds available in this category, and there is 10 years, 15 years of experience of the fund being around. Of course, the relative performance may be very little because in 2018, the categorisation happened. But largely, I would stick to the point that we should wait for the fund performance and then enter.
So, while you are saying that these flexi-cap funds are not true blue, some of these could be good substitutes to large caps. Could you give us some examples of well-managed flexi-cap funds where you believe that the fund house and the manager are doing good things?
Kirtan Shah: Two names that come to mind are Parag Parikh Flexi Cap Fund (PPFAS) and SBI Focused Equity Fund.
I will give a couple of reasons on why they cut the list short for us. First, while you look at the risk adjusted performance of these products versus, let's say even a large cap or the competitive flexi-cap in the category, they have been outperformers consistently. I am not talking about a point-to-point analysis, but about a rolling analysis for at least seven years.
Very importantly, we have been very closely monitoring the fund manager and what he has been saying, in terms of performance or the allocation of the portfolio construct versus what they are really doing on the ground. They are very close to what they have been spelling out versus what they have been doing in the fund.
But one point that I want to highlight is that a lot of other funds are in the same categories and that the fund management team (here) is pretty consistent.
Now, I don’t want to name other funds, but if you look around in the same category, there have been consistent change in the funds and, hence, if you look at the performance, you can't really make an apple-to-apple comparison, because it basically moves 360 degrees with the fund manager change. So, that is another important data point because of which both of these funds stand out.
For the last two weeks, we have seen dichotomous views on what could happen to IT stocks. Are there thematic funds which do large cap or IT investing? If so, is this a good time to invest in some of these?
Kirtan Shah: Yes, there are thematic funds which focus on IT as a sector. Now, if all of us largely look at IT as a space right now, there has been a correction of 25-30% in larger names and most of the stocks.
I think if you look at the last five-year, ten-year valuations of large IT companies, we are probably at 22-25 times versus the historical average of 20, and on the mid cap side, we are roughly anywhere in the range of 28-35 times. Now that's slightly steep versus the average that we have seen.
Can the market discount another 5-10% on the stocks? Very much possible. But if you look at the performance of these sectoral funds, they have generated a significant alpha on a three-year, five-year, seven-year basis specifically to do with allocation to the sector funds.
I will tell you what my problem is with this. Now, if we talk about somebody who has allocation to large cap, somebody who has allocation to Flexi Cap, after BFSI, IT is the biggest sector in which most of these funds are allocated.
If you break down and see the top funds, you will see roughly 15% allocation in most of the funds to technology. Largely if you look at the portfolio construct, you will see 30-35% to BFSI, 15% to IT already there in most of the investing that people will do in terms of diversification.
Even if you have diversified yourself in four or five parts, but your larger concentration to sector–50% is banking and financial services and IT.
The point that I am trying to make here is how long or how much do you really want to take exposure of your overall portfolio to two sectors?
In my opinion, going above 20% allocation to one particular sector can be futile, so probably depending on what your allocation is of your current portfolio to IT... maybe you can push that to 20%.
But I don't think that even if times are really interesting to allocate a lot of money to IT funds, you should really go ahead and take aggressive bets –more than 20% of your total allocation–because most of your funds have allocation to IT and to a significant margin.
Effectively, even if you are at times saying that thematic funds could be a good idea, in the case of IT or may be by extension in terms of banking as well, you don't think that those will be good thematic funds because diversified funds anyways have a large exposure?
Kirtan Shah: Absolutely. Like we said, 50% of the portfolio is massive. I mean we are investing anywhere in the range of 45-50% just in two sectors and, of course, we know both these sectors are large and they are largely FII favourites.
So, we have seen what happened in the last one-and-a-half-year while FIIs have started selling and how both of these sectors have largely reacted. In my opinion, it defeats the purpose of diversification that we are talking about.
While we might theoretically feel that we have diversified across AMCs, across different categories of funds and styles of investing, but you are still largely stuck to two sectors with 50% of your portfolio.
I think there's too much to allocate to two sectors. So, I am a little wary of doing thematic or sector investing, specifically in both of these sectors.