All-Cap FoF: Managing Rotation and Opportunity Across Market Segments

Listed businesses in India are classified as large, mid or small based on their market capitalization. The top 100 businesses are classified as large cap, the next 150 as mid-caps and those beyond the top 250 fall into the small cap segment. While large cap stocks are typically established businesses, mid cap businesses are emerging leaders and small caps are new businesses with high growth potential. Investing in businesses across the market cap spectrum makes investment sense as it enables one to capture growth opportunities across different segments of the Indian economy.

Although the underlying macroeconomic conditions such as GDP growth, inflation, interest rates, fiscal deficits, consumer preferences, regulatory environments, commodity prices etc. are common to large, mid and small cap businesses, their performance often diverges and leadership between these segments tends to rotate. 

Smaller companies may grow faster than their larger peers in high-growth environments but have higher earnings volatility compared to large caps during periods of economic slowdown.  Large caps which tend to have more global revenue exposure are more sensitive to global shocks than mid and small cap stocks which are more domestic economy focused. Valuations also play a critical role. When small and mid-caps trade at elevated price levels relative to history, their future returns tend to moderate. Large caps, if more reasonably priced at that point in time, outperform going forward. Larger stocks are more liquid and typically attract institutional flows keeping stock prices steady, whereas lack of liquidity in smaller stocks can amplify both rallies and corrections.

Given these dynamics, it is prudent to stay diversified across the market capitalizations by holding a mix of large cap, mid cap and small cap stocks through large cap funds, mid cap funds, small cap funds, multi cap and flexi cap funds. But constructing and managing a DIY portfolio of such funds would require investors to assess relative valuations, anticipate leadership shifts and rebalance accordingly. 

Leadership rotation between market segments is hard to predict and investors often end up chasing performance after the majority of the gains have already played out. For investors with limited time or expertise, a Fund of Fund (FoF) that invests in diversified equity funds across the market capitalizations can be a structurally superior way to implement this strategy. 

In addition to providing one-stop solution, such FoFs tactically allocate to large, mid and small cap segments based on relative valuation attractiveness and return potential, relieving investors from continuously tracking market developments and making portfolio adjustments. 

Unlike individual investors who often fall prey to emotions such as panic when markets correct and greed when markets do well, fund managers of these FoFs follow defined processes and frameworks to make portfolio changes, ensuring emotions don’t come in the way of good investment decisions. Also, portfolio changes within a FoF do not result in capital gains tax for the investor. This lets more of the investor’s money stay invested and get compounded, adding to returns over time. 

Recent years have seen sharp and frequent rotation between large, mid and small cap segments, highlighting the importance of a more dynamic, disciplined and efficient approach to equity investing. In such an environment, a FoF designed to invest across market capitalizations can make good investment sense.