Given the nature of India's small-cap market, SEBI's new ruling on multi-cap funds will mean that these funds cannot continue in their current shape
17-Sep-2020 •Dhirendra Kumar
Here's a somewhat alarming prospect for investors of multi-cap funds. These funds are over, done for. Soon, within weeks, most popular multi-cap funds will have to either merge with large-cap funds or change character and become something else. That sounds like a dramatic statement but it's actually the prosaic truth, a sober assessment of the impact of SEBI's new ruling.
If you are an investor in such a fund, especially if you have a substantial amount of money invested in them, then be prepared for a bit of an upheaval in your portfolio.
Let's look at what exactly is happening. As many involved mutual fund investors would have come to know by now, SEBI has brought in a new rule that will force multi-cap funds to invest very high proportions of investors' funds in small-cap and mid-cap companies. As per the regulator, by January 31, such funds should have at least 25 percent of their assets in large, mid and small-cap stocks and this is to be done so that these funds are 'true to label'.
Principally, this is a problem. Even a cursory examination of SEBI's own definition of large, mid and small caps shows that the 25 per cent limits will lead to a drastic over-representation of mid and small-cap companies in multi-cap funds. If you apply SEBI's own definition to the equity market, then 74.1 per cent of the market's value is in large caps, 15.6 per cent in mid caps and the remaining 11.3 in small caps. If a multi-cap fund is genuinely 'true to label' and representative of the underlying markets, then the limits should be around these values.
It is notable that even SEBI's requirement for small-cap funds is that they need only 60 percent in small-cap stocks. I wonder at this strange contradiction. Funds labelled 'small cap' can have 40 per cent in large cap stocks.
It is a fact that many popular multi-cap funds have very little small-cap exposure. I would argue that this is as it should be. Multi-cap does not mean all the caps, all the time. As an investor, I expect the fund manager of a multi-cap to do the job of being underweight in segments that are going to do badly and being overweight in those that are doing well.
Investors have had a hard time with volatility and uncertainty in recent times. To overload a popular and extremely useful type of fund with volatile and hard to manage stocks is not justifiable, either from a practical standpoint of investor interest, or the principled standpoint of being representative of the underlying markets.
What will happen when multi-cap funds adjust their holdings to the new ruling? If funds were to implement it, SEBI's new rules would drastically increase the volatility that investors of multi-cap funds would face. Mid-cap and small-cap stocks are more volatile.
Why do I say 'if' funds were to implement these rules. Surely funds do not have a choice but to implement these rules. Actually, it's the other way around. For multi-cap funds that are above a certain size - say around Rs 5,000 crore or so - it is simply not possible to implement the new regulation without substantially destroying the fund's portfolio. The liquidity and availability of quality small-cap stocks in India is simply not there. There is a real reason why small-cap stocks are just about 10-11 per cent of the market and that underlying reality cannot be wished away by rules and regulations.
Given this reality, while the new rule appears to be asking multi-cap funds to load up on small-cap and mid-cap stocks, what it's actually saying is that multi-caps should be merged with large-cap funds or converted to large-and-mid-cap funds or something else.
In any case, investors need to have a good understanding of what are the exact implications of this new rule and how it will either lead to a fundamental change in the character of their funds, or perhaps sharply increase the volatility.