Regulatory management

Sebi's new circular may lead to an avoidable churn in the market

In a circular last week, the Securities and Exchange Board of India (Sebi) announced a recast of the multi-cap fund category. The regulator decreed that such funds must hold at least 75 per cent of assets in equity, with a minimum of 25 per cent held in each of the large-cap, mid-cap, and small-cap categories. Large-caps are defined as the largest 100 stocks by market capitalisation, mid-caps as the next largest 150 stocks, and small-caps as all stocks below the top 250. The funds have until February 2021 to rejig portfolios, with the Association of Mutual Funds in India (Amfi) due to publish its new list of stocks in January 2021. Under the current definition, multi-caps have to hold 65 per cent in equity but without defined-size allocations. As of August 2020, there were 35 multi-cap schemes, with assets under management of Rs 1.47 trillion. These funds have assets of Rs 96,000 crore in large-caps, Rs 25,000 crore in mid-caps, and Rs 14,000 crore in small-caps. The mid-cap and small-cap segments would need to be pushed up considerably to achieve the desired rebalancing.  

Six months may be a fair time period to rejig portfolios, but anywhere between Rs 40,000 crore and Rs 65,000 crore (taking new inflows into account) will have to be moved into small-caps and mid-caps, presumably by cutting large-cap exposures. It is also a moot point if there is enough float in the small-cap segment to absorb rebalancing of this order. Alternatively, the funds will have to change categorisation, to “thematic” perhaps, to avoid churn. This is an unusual example of micro-management by the regulator and it affects the flexibility of a multi-cap fund. In most large economies, market regulators don’t set such rigid mandates, precisely because these active funds are meant for experienced investors seeking value across segments.

The regulator says it wants multi-caps to be “true to label” but the economic rationale is hard to fathom. Market economies operate on the Pareto Principle with at least 80 per cent of economic value generated by the largest quintile of businesses. India is “hyper-Pareto” with the largest 15 per cent of listed businesses generating over 90 per cent of revenue and profit. In Q1, 2020-21, for a sample of the 1,700 largest listed businesses, the top 30 firms by revenue generated over 53 per cent of all revenues and over 73 per cent of profits after tax. The top 100 firms generated 78 per cent of revenues and 72 per cent of profits. Further, the top 250 firms (encompassing all large-caps and mid-caps) generated 91 per cent of revenues and 96 per cent of net profits.

Given this concentration, it seems to make sense for fund managers to focus on bigger stocks as they have done. Moreover, the valuations of small stocks and mid-caps have historically been in the same range or a little higher in terms of commonly used metrics like the price-to-earnings (PE) ratio. The top 100 listed stocks at the NSE (The Nifty and Nifty Next 50) are trading at an average PE of 33-34. The mid-cap and small-cap segments have both suffered catastrophic shrinkage in revenues and profits, which makes the current valuations of these segments non-representative. But they have historically traded in the same range. In its quest to create truthful labels, Sebi may have set off a churning process, which investors and fund managers could struggle to cope with.