Over the weekend, market regulator Securities and Exchange Board of India (Sebi) came out with two circulars. On September 11, 2020, it tweaked the asset allocation rules of multi-cap funds, which are now required to maintain minimum 25 per cent exposure in each of the market cap classification - large-cap (top 100 stocks in terms of market cap), midcap (101st to 250th stocks) and small-cap (251st stock and below). This has been done to diversify the underlying investments of multi-cap funds across large, mid-and small-cap companies so that they are true to its label, unlike the current allocation that is tilted towards large-cap stocks (around 75 per cent of total multi-cap AUM). Mutual Funds have time until January 31, 2021, to comply with these rules.
Again on September 13, 2020, it clarified that “Mutual Funds have many options to meet with the requirements of the circular, based on the preference of their unitholders. Apart from rebalancing their portfolio in the Multi-Cap schemes, they could inter-alia facilitate the switch to other schemes by unitholders, merge their Multi-Cap scheme with their Large Cap scheme or convert their Multi-Cap scheme to another scheme category, for instance, Large cum Mid Cap scheme. …. It is reiterated that to achieve the desired objective of True to Label and Appropriate Benchmarking, SEBI will examine proposals of the industry, if any, received in this regard.” It has thus given a hint that it will consider the representations of fund houses about the difficulty in implementing the circular and may give some leeway/time for adherence.
These new rules can bring in a broader market rally, as compared to polarised moves seen over the past one-two years.
Many expect several small-and midcap stocks could rally in the early part of this week in anticipation of likely increased exposure by AMCs in these segments. Investors should not blindly rush in and buy any and every stock in these two segments on the back of likely flows by domestic institutional players. Invest only if you are comfortable with the fundamentals and convinced about the growth prospects of the company, as it is the only driving factor in the long haul.
There is no need for existing multi-cap investors to panic or take any action, despite the likelihood of higher portfolio risk if the regulations are implemented in their present form. A better strategy would be to wait for clarity from the fund management. The market regulator might re-visit the circular later and provide some leeway or extra time to multi-cap funds.
That said, investors can look at gradually increasing their mid-and small-cap exposure via exchange-traded funds (ETF)/Index Funds or better still a small-cap or midcap fund.
Large-caps under pressure?
For direct investors into equities, this regulation provides an opportunity. Some large-cap stocks could come under some temporary selling pressure. Benchmark indices, too, are looking at global indices especially the US, foreign portfolio investor (FPI) inflows, and the emerging macro and micro situation in India. This could be a good time to reduce holdings in stocks that have run up too much, or which do not show much promise relative to their prices going by their recent fundamental performance.
Given the size of multi-cap funds and higher allocation, especially to small-cap stocks, some concerns have been raised about achieving the prescribed investment limits without creating a bubble in the small-and midcap stocks. Note that the AUM of small-cap stocks across equity categories (excluding sectoral) as on July 2020 is Rs 68,109 crore – compare this with around Rs 28,000 crore worth fresh buying required. These stocks have less free float availability, relatively lower volumes, corporate governance issues and higher impact cost (both at the time of getting in and getting out). Also, liquidity issues in small-cap stocks could get compounded in bear markets when these funds face redemption pressure and are required to sell small-cap stocks where impact costs could be large.
Most multi-cap funds are benchmarked to either Nifty 500 or S&P BSE 500. The allocation of Large-cap, Midcap and Small-cap stocks in Nifty 500 index is 77.2 per cent, 16.1 per cent and 6.7 per cent respectively, which is more or less in line with current market cap-wise exposure for most of the multi-cap funds.
A new benchmark index would then be required to compare these schemes’ performance. One alternative is S&P BSE AllCap index, where again the split between large-cap, midcap and small-cap is 76.1:15.8:8.1, which is not very different from the split in Nifty 500. Comparing performance of schemes under new Multi-cap prescription of minimum 25 per cent each in midcap and small-cap with any of these indices will be totally misleading. Instead Sebi could have set the minimum exposure of 15 per cent to small-cap, and say 25 per cent to midcap segment, and left the rest to the fund managers’ discretion.
Multi-cap funds with large AUM may face difficulty in re-shuffling their portfolios. Merger of Multi-cap fund with their Large-cap funds or Large & Midcap category could be way out for some asset management companies (AMCs). Some AMCs could re-define the fund to a thematic fund – maybe an ESG fund – and at a later stage launch another Multi-cap fund.
Schemes requiring the least reshuffling include multi-cap funds from Invesco, IDFC, and Nippon, while schemes requiring the most reshuffling include Kotak Standard, HDFC Equity, Motilal Multi-cap 35, Axis, and Canara Robeco Eq diversified fund.
Deepak Jasani is head of retail research at HDFC Securities. Views are his own.