Sebi asks MFs to shield smallcap investor interest amid spike in volatility

Fund houses asked to consider placing caps on investment, prevent first mover advantage

The Securities and Exchange Board of India (Sebi) wants mutual funds (MFs) to put in place an investor protection framework for those investing in smallcap and midcap funds amid a build-up of “froth” in this space. Following directions from the markets regulator in this regard on Tuesday, the industry body Association of Mutual Funds in India (Amfi) has sent a letter to MF trustees, asking them to ensure “appropriate and proactive measures”.

The Sebi directive comes after the initial round of stress tests on smallcap and midcap schemes with large assets under management (AUM) to see if they can manage huge redemptions in the event of a market downturn.

Sebi has recommended measures like putting restrictions on inflows, portfolio rebalancing, and creating a framework to protect investors from the first-mover advantage of redeeming investors.

According to industry experts, Sebi is looking to ensure that during phases of market downturns and the resultant surge in outflows, the first set of investors shouldn’t be at an advantage to those staying invested. 

The advantage can result from the fact that MFs can exhaust the cash and liquid assets to meet their redemption requests, leaving the rest of the investors holding stocks with low liquidity.

The measures can range from putting in restrictions on withdrawals to raising cash levels to resorting to borrowings during such market phases, said a senior MF executive, adding that some of these measures would require changes in regulations.

“In the context of the froth building up in the small and midcap segments of the market and the continuing flows in the small and midcap schemes of mutual funds, trustees, in consultation with unitholder protection committees of the AMCs, shall ensure that a policy is put in place to protect the interest of all investors,” Amfi said in its letter sent to MF trustees on Tuesday.  

In the past few weeks, the smallcap space has witnessed turbulent trades, with the Nifty Smallcap 100 index declining more than 1 per cent on four occasions — the biggest being a 4 per cent crash on February 12. On Wednesday, the index fell nearly 2 per cent.

Sebi has given MF trustees 21 days to disclose the investor protection policy on their websites.

Four MFs — Kotak, SBI, Tata and Nippon — have already placed restrictions on the amount investors can put into their smallcap funds.

Sebi has been in discussion with fund houses that have large-sized smallcap schemes to look out for possible risks amid a sharp surge in inflows, despite elevated valuations. The regulator had reviewed the first set of stress test reports in January and is said to have asked for more data. One of the areas the regulator is looking at is MFs' ownership in the total free float of smallcap stocks.

Typically, shares held by public investors and those not under any lock-in are considered free float. Liquidity risks are higher if the free float is low.

MF ownership in smallcap stocks has gone up significantly as smallcap schemes have attracted large inflows on the back of robust performance. In the calendar year 2023, smallcap and midcap schemes accounted for 40 per cent of the total net inflows into active equity schemes -- receiving Rs 64,000 crore of the total inflows of Rs 1.6 trillion.

In 2023-24, the Nifty Smallcap 100 is up nearly 80 per cent. As a result, the 12-month forward price-to-earnings ratio of the index has surged to 21.7. The 10-year average is 16.5, according to Bloomberg data.

However, most MF executives believe that their schemes are prepared for market downturns as a significant part of the corpus, around 20 per cent to 30 per cent, is in cash and largecap stocks, where market depth tends to be higher.