SEBI has introduced a new category of mutual funds called 'flexicap' funds. The term is hardly a new one for mutual fund investors as there have been funds with this term in their name for many years now. Moreover, the actual funds under the category are also likely to be a new set. All, or almost all, of the funds that have been in the 'multicap' category so far will shift over to this new category. Understanding the multi/flexi story is important for investors who like to be on top of what's happening in their investment portfolios.
Knowledgeable fund investors will recall that back in September, SEBI had brought a new rule which had seriously threatened to undo the entire multicap category. This rule will force multi-cap funds to invest very high proportions of investors' funds in small cap and mid cap companies. By 31st January, 2021, 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'.
True to label means that the funds' real characteristics are what the name of the category promises. Most of the multicap funds, especially the larger ones, have a heavy percentage in large-cap stocks. In fact they look identical to large cap funds. SEBI concluded that 'multicap' meant that all capitaliatisations should be equally represented and thus brought in the 25% rule.
There are some problems with this, some of principle and some of practice. Even a cursory examination of SEBI's own definition of large, mid and small cap shows that the 25% 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% percent of the market's value is in large-caps, 15.6% 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.
However, there's a deeper, practical problem. The Indian equity markets are quite thin on the ground as far as midcaps and small caps go, both in quantity as well as quality. By quality, I mean good companies and by quantity I mean the sheer amount of stock available in the market for trading, that is, liquidity.
Now, after looking at various aspects and interacting with funds, SEBI has created this new flexicap category which, as the name indicates, gives complete flexibility to the fund managers in terms of capitalisation. There is an overall minimum of 25% in equity but beyond that there is complete flexibility. Essentially, the multi has become flexi and that has apparently satisfied the requirement of being true to label. What used to be mutlicap funds will all recategorise themselves as flexi cap and that's that.
So far, so good? Not quite. The practical problem I noted above remains. SEBI's 25-25-25 ratio may not have reflected the underlying market but the principle on which the regulator acted was definitely correct. A knowledgeable investor who wants a balance of large, mid and small cap exposure would invest in a multicap fund but would actually get a large cap fund. Importantly, this would happen not because it was the right investing strategy but because that fund would be too large to be able to buy enough small and midcap stock.
This problem does not get solved by changing names. To be fair, there is no realistic way of solving it. Mid and small cap markets in India are thin. Funds that perform well become large and a large fund cannot have a significant percentage of its assets in such stocks. There is no solution, and there will not be one for a long time to come.
So where does that leave the investor who'd like to invest in good small and midcap stocks. Two ways: one, build up the expertise and do the research to buy such stocks directly. That is, do not go the mutual way at all. For external help, use a service like Value Research Stock Advisor but basically, do it yourself.
Of course, that's not feasible for a lot of people and they need to go the mutual fund route. In that case, one should choose a set of relatively small funds that specialise in small and mid-cap stocks. The big multis and flexis end up being basically large cap funds but the same is not true of funds that specialise in smaller companies alone.
Basically, investors have to reconcile to the fact that given the nature of the Indian equity markets, it takes a bit of effort to invest well in smaller companies. However, the rewards can be worth it.