Sebi's new rules make mutual funds see red

Fund managers to meet regulator, say method used to define size is faulty

The Securities and Exchange Board of India’s (Sebi’s) new rules on ‘categorisation and rationalisation of mutual fund (MF) schemes’ are facing a pushback from managers overseeing assets worth Rs 21 lakh crore ($320 billion). Earlier this month, the markets regulator set rules to define various investment scheme categories offered by fund houses within the debt and equity segments. 

For equity, Sebi enlisted 10 categories which included large-cap-, mid-cap-, and small-cap-focused investment schemes. It further directed fund houses to offer only one scheme per category. The move has impacted almost all fund houses, particularly the bigger ones, as they will have to drastically prune their number of schemes from as much as 14 currently in one category.

However, what has irked fund managers more is Sebi’s definition of a large-, mid-, and small-cap companies. The markets regulator has said the top 100 companies in terms of their full-market capitalisation will be large-caps; those between 101 and 250 will be mid-caps; those beyond 250 will be small-caps. 

At least three top fund managers told Business Standard that their fund house would soon approach Sebi, requesting a rethink on the definition. According to them, the current definition would encourage front-running, force unwarranted churn, increase ‘impact cost’, and sharply reduce the universe of companies for mid-cap-focused schemes. 

Front-running is the act of buying or selling a stock ahead of anticipated action by a fund manager. Impact cost is the cost incurred to execute a large buy or sell order.

“We will be needed to rebalance our portfolios every six months to add or delete stocks to meet Sebi’s criteria. Daily market cap and portfolio holding data is in the public domain. Savvy traders might do front-running as they will be able to calculate which stocks are going to be added or removed. It will also result in a churn of portfolios and increase the impact cost, as most mid-cap schemes may exit a particular scrip at the same time,” said a chief investment officer with a leading fund house.

According to the framework laid down by Sebi, MF industry body Association of Mutual Funds in India, or Amfi, will have to provide a ranking of stocks at the end of June and December, based on their average market cap on both the BSE and the National Stock Exchange. Fund managers will have to rebalance their portfolios within 30 days, according to the updated list. 

For instance, public sector lender Punjab National Bank currently is a ‘large-cap’ stock, as it is ranked 97 in terms of market cap. However, if the stock slips below rank 100, fund managers will have to exit the stock from their large-cap scheme portfolio.

Meanwhile, Sebi has provided 100 and 150 stocks for large- and mid-cap-focused schemes, respectively, to choose from. According to Value Research, currently the universe of stocks for large- and mid-cap schemes is 104 and 250, respectively. The current mid-cap universe has stocks with a market cap between Rs 5,200 crore and Rs 26,000 crore. About 150 of these companies will no longer be eligible for mid-cap schemes and fall in the small-cap category.

“Currently, we go by market cap where mid-cap schemes invest in stocks that have a market cap of more than Rs 5,000 crore. Sebi, for the first time, has officially defined large-cap, mid-cap, and small-cap. Instead of a ranking methodology, it should have gone for a free-float market cap-based cut-off. It would have simplified the process,” said the head of another fund house, adding the industry might soon discuss this issue with Sebi.

Free-float market cap excludes the shares held by promoters or those under lock-in. As this method takes into consideration only the stock that is freely available for trading, it acts as a good filter for liquidity. The fund manager gave the example of Avenue Supermarts, which has a full market cap of Rs 76,000 crore, but a free-float market cap of only Rs 5,300 crore. At the end of September, the assets under management of equity MFs stood at Rs 6.6 lakh crore, and the number of open-ended schemes offered by fund houses was 359.

THE CONCERN AREAS

• New rules pose risk of front-running
• Could trigger unwarranted churn in portfolios
• Rebalancing could increase ‘impact cost’
• Universe of mid-cap stocks will shrink by a third
• Ranking methodology based on full m-cap instead of free-float m-cap