Remember the great Indian mutual funds reboot in 2017, when SEBI sought to standardise schemes across fund houses? With over 40 fund houses offering nearly 1,000 open-ended schemes with significant overlaps, the SEBI’s move then — pre-defined mandates across categories of funds — had helped bring in uniformity and transparency within the industry.

Reviewing its move, SEBI has now gone a step ahead, to ensure that all schemes within the multi-cap fund category adhere to the spirit of the earlier set out mandate. According to SEBI’s 2017 categorisation norms, multi-cap funds had to invest a minimum of 65 per cent of assets in equity. This was the only restriction laid down by SEBI. The discretion to invest across large-, mid- and small-cap stocks was left entirely to the fund manager.

But with most of the multi-cap funds leaning towards large-caps — 70-90 per cent of assets allocated to large caps — SEBI believes that it is necessary for these funds to diversify to be ‘true to label.’ Hence the regulator has mandated that these funds invest at least 25 per cent each in large-, mid- and small-cap stocks.

With fund managers increasingly chasing large-caps over the past two years, SEBI’s move is not without merit. But given the narrowness in the underlying market and limited opportunities in the small-cap segment, the regulator’s diktat of 25 per cent investment in small caps may be difficult to implement at all times, while also ensuring decent returns to investors.

SEBI’s subsequent clarification that existing multi-cap funds can meet the new norms in multiple ways — through facilitating switch to other schemes or merger of schemes — aside from rebalancing of the portfolio, does help allay investor concerns and ensure minimal disruption in the market. This is indeed welcome.

Reviewing its 25 per cent mandate for investment in small-caps and creating another category (flex-cap) where fund managers have full discretion to invest across the market capitalisation spectrum — would further ease market concerns and serve investors better.

Not enough diversification

There are currently 10 sub-categories of equity funds. Of these, five are defined by SEBI based on market capitalisation of stocks. For instance, large-cap funds have to invest at least 80 per cent in large-cap stocks; large and mid-cap funds must invest at least 35 per cent each in large- and mid-caps; mid-cap and small-cap funds are to invest at least 65 per cent in mid- and small-cap stocks, respectively.

To ensure uniformity across funds, SEBI has also defined large-cap (between 1st and 100th based on full market capitalisation), mid-cap (101st to 250th) and small-cap stocks (251st onwards). The list is available on the AMFI website and updated every six months.

Multi-cap funds understandably stood out for the discretion they lent to fund managers to invest across the market capitalisation spectrum. SEBI’s move to limit this flexibility appears to have been led by the skewness in the portfolio of these funds.

Currently, over two-thirds of the schemes within the multi-cap fund category have 70-96 per cent of large cap exposure. Of the total AUM of about ₹1.48 lakh crore under multi-cap funds, about 74 per cent is in large-caps, while only 17 per cent and 5 per cent is in mid- and small-cap stocks respectively.

In fact, majority of multi-cap funds in the past two years have had over 65 per cent exposure to large-caps (some even holding 80-90 per cent in large-caps) leading to overlaps with large-cap and large and mid-cap funds category. SEBI’s move is intended to bring in more diversification of assets under multi-cap funds — capping exposure to large-caps at 50 per cent.

But the regulator may also need to appreciate why multi-cap funds carried a penchant for large-cap stocks over the past two years.

Why the skewness?

In 2018 and 2019, mid- and small-cap stocks underperformed large-cap stocks significantly. In fact, many of the smaller stocks fell like ninepins. The carnage cost mid- and small-cap funds dearly, that lost 12-18 per cent in value in 2018. Large and mid-cap and multi-cap funds capped their losses to 5-7 per cent. Large-cap funds managed to deliver a modest 1 per cent (average) return that year.

To cap further losses, multi-cap funds began increasing their exposure to large-caps towards the end of 2018 — from 48-55 per cent to over 70 per cent. Retaining large-cap bias helped these funds hold their heads above water in 2019, as mid- and small-cap stocks continued to plunge lower. Multi-cap funds delivered on par returns with large-cap funds in 2019 (9-10 per cent) and so far in 2020 (negative 5-odd per cent).

Essentially, fund managers used their discretion to cut exposure to mid- and small-caps to ensure decent returns to investors. While some funds may have gone too far — holding over 80 per cent in large-caps — can doing away with fund managers’ flexibility entirely be in the best interest of investors?

Multi-cap funds are often preferred by investors with a moderate risk appetite and they choose to rely on the wisdom of the fund manager to juggle between large- and mid/small-cap stocks. A minimum 25 per cent exposure to mid- and small-caps may well turn one set of investors away from multi-cap funds for good.

But importantly, SEBI appears to have overlooked the underlying issue with the market, which may make it difficult for fund managers to meet the 25 per cent mandate at all times.

Shallow market

In recent times, the market movement has been led by a handful of over-priced large-cap stocks. For instance, in 2019, while Sensex gained by a tidy 14 per cent, over 70 per cent of stocks (traded) fell during the year.

Mutual funds, to some extent, may have contributed to this narrowness by increasingly chasing expensive large-caps. But it is a chicken and egg situation, where fund managers too are limited by the shallowness in the market.

In 2017, before the carnage began, small-cap stocks constituted about 14 per cent of AMFI’s list of stocks (by market cap). Currently (January-June 2020 list), only 9 per cent comprise small caps. Of the overall AUM of all equity funds (SEBI’s defined 10 categories of equity funds), about 23 per cent are in mid-cap and 9 per cent in small-cap stocks. It would appear that funds’ choices only reflect the underlying breadth in the mid/small-cap universe.

Hence, given the narrow universe of good small-cap stocks and limit on individual stock exposure (10 per cent) in schemes, meeting the 25 per cent threshold may be a difficult task for multi-cap funds at all times, without exposing investors to higher than desired risk and subdued returns. SEBI may need to review this limit.

The market was expecting significant disruption, as re-balancing portfolio of existing multi-cap funds would imply about ₹42,000 crore of assets moving out of large-caps and into mid- (about ₹12,000 crore) and small-cap stocks (nearly ₹30,000 crore). But post SEBI’s clarification (on switching and merging of schemes) such market gyrations seem unlikely, also as funds have time to comply with the norms (by February 1, 2021). Hence investors should avoid taking any rash decisions without further clarity from the fund houses.

But SEBI’s move could still lead to some disruptions in the market, similar to the ones witnessed post its 2017 directive. Strict mandates for large-cap funds then, had forced fund managers to trim exposure to mid/small-cap stocks (contributing to some extent to the existing narrowness in the market). Rather than going back and forth on mandates, the regulator will have to step up other efforts to broaden the market — reviewing the construct of the Sensex or Nifty 50 (highly skewed towards a handful of stocks), facilitating a more vibrant primary market, and greater participation from insurance companies, among others.

Above all, if the regulator is keen on setting investment limits in multi-cap funds, then it may have to consider a new category of fund (flexi-cap funds) which gives full freedom to fund managers to invest across the market capitalisation spectrum.

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