New Rules From SEBI On Multicap Funds

On a quiet Friday evening, 11^th Sep 2020, when almost all the hullaballoo of Capital Markets ended for the day, SEBI, the Indian Capital Markets regulator issued a new set of guidelines for the Equity Multicap mutual fund schemes.  These new set of regulations immediately set the twitter, TV channels, newspapers on fire with their interpretation of these new guidelines and its impact on the stock markets, particularly on the mid and small cap stocks.

In this note we look at the SEBI’s new regulation and what possible changes we may see in this space.  Please note at this stage, this is just our understanding of the current situation and as things evolve we will update you.

Development as of 13^th September, 7.00 pm:

SEBI has issued a clarification giving multiple options for the Asset Management Companies to work around the new regulation.  We believe that it opens up various possibilities for the fund houses to manage this regulation without adding up much of small and mid cap stocks.

Summary of the SEBI Regulation of 11^th Sept 20 on Multicap funds

In October 2017, SEBI came up with the original rules regarding categorization and rationalization of mutual funds. 36 different sub categories were defined with 10 of them for pure equity funds. Specific rules were defined for each sub category.

Yesterday, SEBI revised the asset allocation rules for multi cap funds. The key changes are:

• Market cap specific limits – the multicap fund now has to have a minimum of 25% each in large, mid and small cap companies. There were no such sub limits earlier.
• Increase in minimum equity exposure from 65% to 75% – Earlier multi cap funds had to have a minimum of 65% of their money in equities. This limit has now been increased to 75%

Mutual funds have to comply with the above regulation within one month from the date of publishing the next list of stocks by AMFI, i.e. January 2021

What are these large, mid and small cap companies?

AMFI publishes the list of stocks by market capitalization (Total number of shares multiplied by the current share price).

• Large Cap – The top 100 companies by market capitalization
• Mid Cap –  101-250 by market capitalization make up the midcap universe
• Small Cap – All companies from 251 and beyond

Current Market Cap allocations of Multi cap funds

Mutual funds across all their schemes hold about 7.7 lakhs crores of investments in equities. Multicap and Large cap categories have the highest market share of roughly 1.45 lakh crores each. The mid (90,000 crores) and small cap (50,000 crores) categories are relatively smaller in size.

Multicap funds, as a category across all the Asset Management Companies, currently have the asset break up across market capitalization as follows:

• Large Cap Stocks – 72%
• Mid Cap Stocks – 16%
• Small Cap Stocks – 6%

So, as per the new regulation, they have to maintain investments in the mid cap and small caps stocks at a minimum of 25% each.

 What are the key implications of this regulation?

To reach these levels as now mandated by SEBI, the mutual fund schemes have to buy mid and small cap stocks worth some 40,000 crores.  This can drive prices of mid and small cap stocks in the short run.  That was the biggest reason for all the noise around this new set of regulation by SEBI.  Assuming that the categories are not changed and the investors don’t switch, this regulatory change may have a major impact.

• Small cap stocks may get a one-time 25X Booster of monthly investments!! We may see purchase of small cap stocks for 27,500 crores over the next few months by mutual funds. To give an idea of this magnitude, in August, small cap funds received 1,200 crores as gross purchases and the net flow was negative 100 crores (meaning, investors withdrew more than they invested in). So, this amount of 27,500 crores will be huge if you look at small cap stocks
• The entire Assets under Management (AUM) of small cap funds itself is about 52,000 crores. So, the proposed investments will be equal to a 50% increase in mutual fund exposure to small cap stocks
• Mid cap stocks will get a one-time 8X Booster! The mid cap stock investments by mutual funds may exceed 12,500 crores over the next three months. In August 2020, mid cap funds saw net flows of negative 600 crores

What may happen between now and Jan 2021?

 These changes are considered huge and it has come without any indication from SEBI.  The fund houses have already started working on their strategies to meet the new SEBI norms on their multicap funds.

One of the fund house CEOs tweeted Friday evening that they have already identified a possible solution which may help them to maintain status quo on their portfolio.  Another fund house CEO, who runs a very large sized Multicap fund, mentioned on a zoom call very clearly that they are looking at all options and not going to rush to buy the mid and small cap stocks.

So every fund house will come with their own strategy to manage this transition with least to minimal impact on their Multicap portfolios.

• Fund houses may change multicap funds to a different category by merging with other schemes or follow up with SEBI for some kind of relaxation in the rules
• Some fund houses with smaller AUMs may go ahead and change the portfolio composition to match the new regulations

Some of the bigger Multicap funds which has higher AUMs will have a real challenge in managing this transition.  So, if the new regulations gets implemented without any change by the appointed date of 31^st January 2021, we may see:

• Increased buying in small cap stocks – The top 6 multi-cap funds have 105,000 crores in assets, but they hold only 6% in small caps while they are broadly compliant with the mid cap guidelines. They alone have to put in 25,000 crores in small caps.
• Short term volatility – As the fund houses exit large caps and add more small caps, this may result in short term volatility in the market as a whole

 What does this mean for us as Investors?

We continue to live in very interesting times! We are once again witnessing one of the biggest risk in investing, the regulatory risk! We saw that in 2017 in the form of original MF recategorization rules and the impact it had on the markets.

There is a big expectation on the upward movement of mid and small cap stocks in the short term.  True that liquidity may be a huge driver of short term performance of any asset class, in the long run stock returns will be based on earnings growth and improved operational performance of respective companies.

We would advise as follows:

• Retain the trust in High Quality fund managers – The golden rule to successful investing is to identify high quality fund managers and maintain our conviction in them.  Post SEBI recategorization, several fund houses shifted their best fund managers/philosophies to the multi cap space because of the flexibility it offered.  Rather than trying to second guess every move, we should continue to retain our conviction in these quality fund managers and wait for their decision
• Revisit risk appetite with increased allocation to mid and small caps – The increased exposure to mid and small cap stocks may increase the volatility of multicap funds in general.  Based on the extent of multi-cap exposure in the portfolio and also on what each fund does, we will have to decide on a case to case basis.  We will do any changes in the portfolio as more clarity emerges in the coming weeks and months.  No need to rush for any immediate action.  We should stick to our planned allocation based on our long term goals and risk appetite.