SEBI Changes In Multi-Cap Funds: Double-Edged Sword For Investors?

By: Tavaga Research

The Securities Exchange Board of India (SEBI) revamped the structure of multi-cap mutual funds by tweaking their categorization in September 2020. The market regulator also introduced a framework concerning asset allocation of multi-cap funds.

From the present requirements of 65 percent as a minimum threshold in equity and equity-related instruments, fund managers must ensure a minimum allocation of 75 percent towards equities. The regulator has taken a step ahead and directed the fund houses to invest at least 25 percent of the multi-cap fund’s corpus in small-cap, mid-cap, and large-cap stocks each.

The Mutual Funds are adhered to comply with the new regulations within one month from the date of publishing (January 2021) the list of stocks under various categories by AMFI. Notably, AMFI was not consulted by SEBI before releasing the circular on the latest norm.

SEBI justified this move by stating that mutual fund investors will reap higher benefits from diversification and multi-cap funds will uphold the philosophy of their label. Multi-cap funds have been noticed to invest with a bias toward large-cap stocks citing the risk-averse nature of fund managers and unitholders. The large-cap bias also comes with additional liquidity offered by large-cap stocks as opposed to mid-cap or small-cap. Liquidity aids the fund manager to handle cash requirements of the funds by executing large-cap trades and easily raising cash.

Previous Instances of SEBI’s Interference in Recategorization of Mutual Fund Schemes:

The latest notification comes at a crucial stage as the regulator had made it difficult for fund managers to invest in small and mid-caps by issuing norms on the re-categorization of mutual fund schemes in 2018. Earlier, there was no particular definition of large-cap, mid-cap, or small-cap stocks. Mutual funds on their discretion defined the categories. As per SEBI’s definition, the top 100 companies by market capitalization were to be considered as large-caps, mid-caps were defined as 101^st to 250^th and 251^st onwards were defined as small-caps.

SEBI’s recategorization norms of 2017-18 further directed the mutual funds to invest at least 65 percent of the small-cap fund’s corpus into small-cap stocks. With this, small-cap funds did not have the freedom to move from small-cap stocks to mid-caps or large-caps beyond the maximum threshold of 35 percent and thus had to enforce curbs on inflows into small-cap funds. This move by SEBI led to small-cap and mid-cap stocks witnessing a fall of 60-80 percent.

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What are the Challenges that Multi-Cap Fund Managers will Face?

• Mid-caps and small-caps offer low liquidity in terms of finding buyers and sellers in the market. Therefore, increasing exposure in the sector will be done at the expense of liquidity. The question is whether the small-cap stocks can support such buying pressure.

• A limit of 25 percent would also be placed on the international equities that are a part of multi-cap funds. While 75 percent of the total assets will be reserved for large-caps, mid-caps, and small-caps, the fund manager has the right to use the rest 25 percent at his discretion. However, the fund managers also have to keep a certain percentage of cash, which limits their freedom to invest as they wish.

• Unfavourable movement of prices due to short term rally in small-cap and mid-cap stocks can lead to a rise in impact costs for multi-cap funds as these categories of stocks are less liquid.

• Fund managers may resort to applying for a reclassification of the fund instead of wide-scale churning of the portfolio. Reclassification of a fund means changing the philosophy and investment objective of the fund to suit the portfolio allocation.

• Fund managers may also explore the option to merge with other funds to meet the classification needs which also happened when SEBI tweaked classification norms in 2017-18.

• Furthermore, fund managers approached the market regulator for a relook as most multi-cap funds across the mutual fund segment fall on the wrong side of the fence with very low exposure to small-caps. Fund managers with large-sized multi-cap mutual funds also sought a flexi cap category from the regulator.

• The recent changes suggested on the evening of 13th September 2020 via circular 46/2020, allowed fund managers to assist the switch to other funds by unitholders.

How will the new SEBI Circular affect Multi-Cap Funds?

• The added risk due to the inclusion of more small-cap and mid-cap stocks, may not necessarily mean higher return as portfolio constraints may keep the fund manager from creating supernormal returns

• Multi-cap funds will witness portfolio churning as fund managers adapt to the new norm. The securities closer to the borderline of market cap classifications, for example, 101^st or 251^st stock, will demand portfolio churning as they witness volatility

• Adherence to the new requirements will trigger rebalancing across multi-cap portfolios. However, the SEBI further clarified that rebalancing was not the only option available to multi-cap funds.

What does it mean for Small-cap, Mid-cap, and Large-cap stocks?

The notification came as a surprise to many pundits, some appreciated this forced mandate by the regulator as it makes the multi-cap fund true to its label. There were quite a few who termed it as a regulatory overreach.

Out of 35 multi-cap funds, as many as 32 funds have an exposure of more than 50 percent towards large-cap stocks; 28 funds out of these have large-cap allocation between 65 percent and 92 percent; 27 multi-cap funds have an allocation of 10 percent or less to small-cap stocks. Mid-cap stocks comparatively form a bigger portion of multi-cap funds with 21 schemes having exposure of 15-39 percent to mid-caps. (Source: Morningstar)

As depicted by the graph, the top funds by AUM are not even slightly close to the required minimum investment in small-cap. Some of the funds have more holdings in cash as opposed to allocation toward small-cap. The combined AUM of the funds mentioned amount to close to Rs 80,000 crore which is over 50% of the AUM under the multi-cap mutual fund category. 

Morningstar data suggests that fund managers would have to offload Rs 40,700 crore worth of large-caps and deploy Rs 27,700 crore towards small-caps and Rs 13,000 crore towards mid-caps.  This move can certainly lead to a rally in small-cap and mid-cap stocks. Hence, the biggest indirect beneficiaries would be small-cap and mid-cap funds who were mandated to account for at least 65 percent of their total corpus into small and mid-cap stocks.

However, if the current multi-cap funds opt for conversion into a large-cap and mid-cap fund, small-cap stocks that belong to such multi-cap funds will face the risk of offloading.

What does this change Mean For Investors?

Existing investors in multi-cap mutual funds may decide to exit such funds pointing to the upward revision of risk factors associated with small-cap funds. Therefore, investors may turn risk-averse and re-allocate their capital towards moderate risk investments. This poses another challenge for fund managers to advertise their funds.

A buying opportunity in the small-cap sector seems plausible. Rebalancing of portfolios is likely to initiate a short-term uptrend in the broader markets. Fund managers on the lookout for small-cap stocks will deploy capital toward stocks that have exhibited strength in the current market situations. Therefore, stocks that are a part of outperforming small-cap mutual funds may witness a surge in demand.

What does it mean for the Broader Markets?

The data implies that small-cap stocks are deprived of potential participation from domestic institutions. Broader markets, such as mid-cap and small-cap sectors, are likely to experience a surge in equity capital infusion to the tune of Rs 40,000 crores. The move is likely to enable small-cap firms to raise more capital on the backdrop of increasing valuations. Such an event will address the disparity in the allocation of capital between benchmark stocks and broader market stocks.

In November 2020, the SEBI introduced a new category of mutual fund named the flexi cap mutual fund. The flexi cap mutual fund category enables fund managers to recapitalise their schemes with a minimum of 65 percent of their assets invested in equity and equity-linked instruments, without restrictions on market cap categories.

Thus, the new SEBI norm might provide the push for firms affected by the Covid-19 pandemic along with the loan restructuring option that was given to firms by the RBI for a period of six months.

With the nearing deadline for AMCs to rebalance their respective multi-cap schemes to ensure that 75% of their assets are invested in equity and equity-linked instruments, a few fund houses have decided to switch to the newly introduced flexi cap fund. To name a few, Motilal Oswal Mutual Fund, Kotak Mutual Fund and Axis Mutual Fund have decided to move their multi-cap schemes to the flexi cap category.

To conclude, the turn of events to follow will give way to lucrative opportunities for investing in the equity markets.