Multi-cap funds: The impact of SEBI’s regulation

By Morningstar |  12-09-20 | 

According to a decision made by the Securities and Exchange Board of India, multi-cap funds must have minimum exposures to all market caps.

So according to the latest regulations regarding the portfolios of equity mutual funds:

  • Large-cap fund: Minimum 80% in large-cap stocks
  • Mid-cap fund: Minimum 65% in mid-cap stocks
  • Small-cap fund: Minimum 65% in small-cap stocks
  • Multi-cap fund: Minimum 25% in small-cap stocks, 25% in mid-cap stocks, 25% in large-cap stocks

Three investing professionals share their different views on the subject.

Amit Mantri is a fund manager at 2Point2Capital. You can follow him on Twitter.

The SEBI move is bizarre and another instance of regulatory overreach. It is difficult for a fund to operate under such inflexible criteria. At this rate, India is becoming “no country for active fund management”.

The initial reaction may be that small caps benefit from this, but in the long term, small caps will be hurt the most. I say this because many of the larger multi-cap funds will just change their classification to Large and Mid Cap and cut even the little small-cap exposure that they have. Do note that most of the large multi-cap funds anyway have very little small-cap exposure.

Only funds with smaller AUMs can think of a 25% small-cap exposure. Large funds with less than 5% current small-cap exposure can't increase it to 25%. The latter would prefer a Large and Mid Cap classification, which is anyway what they truly were.

Fewer multi-cap funds will be launched in the future. Quite likely that in the long term, mutual fund allocation to small caps comes down because of this. Small-cap flows will decline in the long term.

Sunil Singhania is the founder of Abakkus Asset Manager. You can follow him on Twitter.

Multi-cap funds by name and nature should be investing in stocks across market capitalizations. A lot of mutual funds were just using the name multi-cap but for all practical purposes looked like large-cap funds. Why would you offer a multi-cap fund that has 80% of its portfolio in large caps? You are doing the investor a disservice. It goes against the basic philosophy of the fund.

What the industry was missing after the categorisation rule came into effect in 2017 was broadening of the market. Since money was flowing into the top large caps, they were trading at 80PE multiple, while the rest of the market was being ignored. Consequently, mid and small cap companies were struggling to raise capital which is needed for the company and economy to grow.

The regulator must be applauded for this move and given credit.

RamaKrishna Vadlamudi is an investment professional and CFA Charterholder. You can follow him on Twitter.

While I do believe that SEBI should not constrain a fund manager's ability to move among various stocks and distort the markets by resorting to back-seat driving, I would like to point to the dramatic statements being made in the media.

There seems to be a notion that thousands and thousands of crores will move from large-cap stocks to mid- and small-cap stocks in the light of the changed SEBI regulations.

I do think this is a bit naïve. One must also consider the second- and third-order effects.

As per SEBI's rules on categorization, there are 10 types of equity mutual funds. Let us assume that the new rules will lead to a lot of churn as funds start selling large caps and move to small and mid-caps. This will affect all the other 9 categories.

Why? Because small caps become mid caps, mid caps become large-caps, and large caps shrink into mid caps. At least in theory. As one category of equity mutual funds sees selling, another would witness buying. Due to this, overall selling and buying may be muted.

Moreover, the new categorization rules will come into effect only in February 2021.

The transition should be much smoother than is anticipated.

As per George Soros' reflexivity theory, "markets can influence the events that they anticipate." If sufficient market participants expect the Rs 40,000 cr bonanza, then money may move to small- and mid-cap stocks as is being theorised now. I do believe the chances are remote.

Let me explain with some examples.

HDFC Small Cap has 70% of its assets invested in small caps. Assume small-cap prices shoot up as is being speculated. The allocation of small caps in this fund may reach 75%. Due to liquidity concerns, the fund manager will bring down the small-cap stake.

ABSL Frontline Equity has 85% of its portfolio in large caps. Due to the anticipated shift from large cap stocks to lower market caps, the large-cap allocation may shrink to 75%. At which time, the fund manager may be forced to increase the stake in large caps to 80%.

My point is that the situation will be in constant flux, affecting all sorts of equity funds – large cap, mid cap, small cap, balanced, hybrid, thematic and sectoral.

Now let us further assume that more than Rs 40,000-cr or Rs 50,000 cr mutual fund assets would move from large caps in the next two months. This would put pressure on large-cap stocks leading to drop in the Sensex and Nifty. This drop may further lead to selling which could precipitate more selling. This feedback loop will lead to erosion of mid- and small-cap stock prices.

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Ramji POrwal
Sep 14 2020 12:58 PM
 This is quite balanced view among all the other articles I have seen. My own assessment is that the expectation of large money going to small cap can be termed as Market frenzy/speculation only. Many funds can migrate to other categories without merging with other fund for AMCs and the actual impact over next 4-5months would be minimal.

Plus the impact of market return will be low single digits in any rational calculation.
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