Multi-cap vs Flexi-cap: How Rigid Allocation Can Backfire In Volatile Markets

Buoyed by the multi-year rally in mid and small-cap stocks, investors are now questioning where the new money needs to flow as markets get volatile from here in 2026. While both multi-cap and flexi cap mutual funds invest across large, mid and small-cap stocks, experts say the real difference lies in how much freedom fund managers have to navigate expensive valuations and market corrections.

The investment strategy of multi-cap and flexi-cap funds includes investments in large, mid, and small-cap companies; however, their regulatory structures differ greatly. According to SEBI categorisation rules, multi-cap funds should allocate not less than 25 per cent of their portfolios to large, mid, and small-cap companies, leaving 25 per cent free. Conversely, flexi cap funds should allocate not less than 65 per cent in equities without restriction on the type of market capitalisation.

“That is crucial during the period of elevated valuations. The 2021-2024 bull run was beneficial for multi-cap funds due to the rally in mid and small-cap stocks. According to categorisation numbers, the return for multi-cap funds was about 21.38 per cent, while the return for flexi-cap funds was 17.97 per cent. Nevertheless, that excess return was achieved at a cost of high levels of embedded risk because multi-cap funds had to be invested in mid and small caps even if their valuations were unattractive,” says Rajani Tandale, Senior Vice President, Mutual Fund at 1 Finance.

The problem here was that the valuation of mid and small caps had moved well above comfort levels. Nifty Midcap 150 PE has been at mid-30 levels of late, while past records suggest that the indicator has touched 45x plus levels in the last two-year valuation cycle. Even small-cap valuations had stayed elevated amid the rally in the broader market. Under such circumstances, multi-cap managers couldn’t reduce their allocation below the mandate level of 25 per cent in the respective segments, whereas flexi-cap managers could opt for large-cap stocks or cash equivalents.

“That is the reason why flexi-cap schemes usually perform well through volatile periods. A multi-cap fund usually has a tendency to outperform during widespread equity market uptrends. Nevertheless, multi-cap funds are known to experience larger drawdowns on mid and small-cap corrections. The recent correction in January and February 2024 saw HDFC Multicap’s drawdown at ~20% levels, whereas HDFC Flexi Cap saw a lower ~13 per cent. This has to be pointed out as a scheme-level observation rather than a category trend,” says Tandale.

The regulatory structure has created a liquidity angle. Small and mid-cap categories are subject to increased redemption pressure in the event of a sell-off, which is why SEBI asked AMCs to submit their stress-test results for these categories in 2024. This once again underlines the importance of liquidity within a portfolio, as it is an important aspect of both maximising returns and minimising risk.

“As we move into 2026, the anticipated growth in earnings will slow down, and the disparity in valuation multiples will persist, making fund structure crucial. Multi-cap funds are ideal for investors who need to invest in all three market sizes and are willing to take on more risk, while flexi-cap funds are better for those who want more control over their investments and can adjust their risk based on market conditions,” says Tandale.

The key takeaway is that multi-cap funds are more forcefully and rigidly diversified, whereas flexi-cap funds offer valuation-led tactical allocation.