At the stroke of a pen . . .

At the stroke of pen, yesterday evening, SEBI changed the destiny of many Multi-cap funds & also fate of many investors. Probably, SEBI did this in spirit of having TRUE TO ITS LABEL for multi-cap category of funds. Rightly so ...

Till yesterday, since 2018, Multi Cap funds were defined as market cap agnostic funds. These were diversified equity mutual funds which can invest in stocks across market capitalization. Only condition was 65% exposure in equity to be defined as an Equity Oriented Fund. Now, with circular of yesterday, Multi-cap Funds need to have at least 25% exposure in Large Cap stocks, 25% in Mid Cap Stocks & further 25% in Small Cap stocks. Balance 25% can be invested based on fund managers views.

Just to clarify - since 2018, SEBI has defined Large-cap stocks as the largest 100 stocks by market capitalization, mid-caps as the next largest 150 stocks and small-caps are all the stocks below the top 250 in size. And this list gets re-visited every quarter.

Prima-facie, if this circular is implemented without any changes,  it may have major impact on mutual fund (MF) industry and MF investors. Closer to Rs.1.4 Trn (Rs.1.4 Lac Crore) is total AuM of Multi-Cap category & its Large-Cap heavy (almost 67%). To ramp up existing Mid Cap & Small-Cap to stipulated level of 25%, it may need investment of Rs.12k Cr in Mid Cap stocks  and Rs.22k Cr in Small Cap stocks. The larger positive impact is obviously going to be on Small-Cap stocks. We estimate that currently the domestic MFs have about Rs. 500-600 bn invested in Indian Small-Cap stocks. This may have a huge impact - considering that this needs to be achieved by month of Feb'21.

Impact on Investors -

1. Investors, who have been investing in these Multi-cap funds because of existing investment strategy, which has played out well over last few months and years (or, let me put it in other words - it jelled well with risk & return expectations of investors), may see change in return behavior of their invested funds. It basically will change the risk profile of this product category. It may not fit well in clients risk- return expectations.

2. From investors perspective, it becomes really illogical that fund manager buys stocks, because of some change in norms on categorization. Till date, fund managers were buying stocks, in a particular mutual fund scheme, because they saw investment potential in such stocks. And now with this circular, if portfolio gets re-shuffled in major way, just to follow new SEBI circular, may kill the objective of investing in a particular fund scheme. It may create sense of DIS-TRUST towards mutual fund as a broader product.

3. When fund managers implement this circular as it is - there could be significant impact cost while increasing exposure to Mid & Small Cap stocks. This may impact the future performance of these flagship fund schemes.

4. Assuming that this circular is implemented as it is, and when market is bad, exiting from these funds become difficult for fund managers/investors, as liquidity generally evaporates in small-cap stocks, during bad time. Probably fund managers need to maintain high cash component, all the time.

Alternative Strategies -

Considering these above-mentioned factors, we think, it is unlikely that fund houses will implement this circular as it is. And there are few viable options which few of large fund houses may opt for -

1. SEBI may create one more category of funds - FLEXI CAP and therein fund managers may have full flexibility. It could be TRUE TO ITS LABEL - market cap agnostic.

2. Few fund houses may decide to merge their existing Multi-cap fund with another existing schemes - say Large Cap Fund or Large & Mid Cap Fund or ESG Fund. And re-launch new Multi-cap fund with stipulated allocation across various market cap baskets.

3. Few fund houses may decide to re-position their existing fund schemes with-out merging with another schemes, in case if they don't have any fund in that particular category.  Example, if a particular fund house does not have any Large & Mid cap fund, then they may just re-position existing Multi-Cap fund as Large & Mid Cap Fund.

All the above-mentioned options can be implemented with proper legal process of informing regulator and investors about respective changes.

Besides this, there could always be option to suggest SEBI to provide more time frame to implement this change. Also, there could be an option to return the money to investors as this change becomes difficult to be implemented in short time.  However, we think, no fund house will prefer to do that.  

What should I do as an Advisor / Investor?

With this announcement, there could be sharp rally in Mid-Cap stocks and Small-Cap stocks as few players may like to seize this opportunity. Probably few of small size Multi-Cap fund managers may decide to implement this circular immediately.

We also agree that this is a major announcement and this shall change investment dynamics in major way, still we shall suggest investors to avoid any major hasty action. We are sure all these fund houses shall decide their future course of action, in the interest of investors. Once fund houses decide their own future strategy of managing & positioning this particular fund category, then investors may take a call - to continue to HOLD or to SWITCH to other fund category/fund scheme, based on its fitment in to investors risk profile.