SEBI recently announced a modification in the investment norms for Multi Cap Funds. As a result, there is an expectation that small and mid caps stocks could rally as AMCs would need to forcibly buy significant amounts of mid and small cap stocks.
Let me start by giving you a quick background that can help you build a perspective on the issue. Prior to the new SEBI guidelines, multi cap funds needed to invest 65% into equities. As per the new guidelines, multi cap schemes need to invest at least 25% in the large cap, 25% in mid cap and 25% in small cap stocks.
Large, mid and small cap funds are defined in terms of the full market captialistion of stocks. The 1st – 100th company are Large caps, The 101st – 250th company are mid caps all the companies beyond the 251st company are small caps.Â
Multi cap funds would need to meet this guideline by January 2021. As per AMFI data, the multi cap category is Rs 146,708 Crores as of August 31, 2020. Since the investments in this category are skewed towards large caps, there will be a need to re-balance the portfolio by selling large caps and buying mid and small caps to meet the regulatory requirements. At a category level, it is estimated that multi-cap funds will have to buy around Rs 25,000 Crores of small cap stocks.
Will these guidelines lead to a rally in mid and small cap stocks?
I have been amazed at the speed with which there is a general consensus that has been built around this subject. Many analysts believe that the multi cap fund managers have very little options in the way that they can rebalance their portfolios. The expectation is that fund managers will have to sell off large stocks and buy small caps to meet the regulatory requirement. Will this really happen?Â
Equity funds are facing redemptions!
First, the market sentiment is weak. As per AMFI data, there is a net outflow in the equity category. These outflows amount to Rs 2,480 Crores and Rs 3,999 Crores in the months of July 2020 and August 2020. The outflow from the multi cap funds too have been significant. As per AMFI data, the total outflow in the multi cap category is to the tune of Rs 2,090 Crores in the months of July 2020 and August 2020. If this trend continues the fund managers of multi cap funds can meet the regulatory requirements by just selling off the large cap stocks. Hence the expected buying by fund managers in the mid and small cap category may not materialize to the extent that some investors are expecting.Â
Mid cap and Small cap are facing redemptions too! The mid cap and small cap funds have a net redemption of Rs 1,181 Crores and Rs 195 Crores in the months of July-August 2020 respectively. The inflows will have to grow significantly for these fund categories to create a demand for mid and small cap stocks.
The fundamentals are weak!
Second, the economy has still not recovered from the impact of COVID 19. In times of stress, mid and small cap companies get impacted much more than their large cap counterparts. It is unlikely that investors will completely ignore the economic realities and rush to buy mid and small cap stocks. You must keep in mind that the earnings contraction is far more significant in mid and small cap stocks as compared to their larger peers.
What if retail investors were to rush to buy small caps?
Third, there is an expectation that there could be significant inflows from PMS schemes and retail investors. If this results in some price appreciation, the percentage holding of these stocks automatically goes up  in the mutual fund scheme and hence this will again reduce the need to buy mid and small stocks by the fund managers.
The AMC Options
Fourth, the Asset Management companies have several options to reduce inflows into the affected category. They can reduce commission rates and hence make it less attractive for mutual fund distributors to market these products. They can restrict or stop inflows temporarily. As a last resort, they could decide to re-position the scheme by merging it with another fund category.
AMFI can make a represntation too!
Fifth, if this is really such a big issue, AMFI would represent to SEBI as no asset management company would like to do anything that could hurt the interests of the existing investors. If there is merit in their arguments, SEBI could consider making the necessary adjustments.
Conclusion
In conclusion:
(a) There could be a rally that may happen in small caps in expectation that mutual funds will be forced to buy small and mid cap stocks. But in reality, the rally may actually fizzle out as these expectations do not materialise due to the reasons I have shared above.
(b) The larger schemes in multicap could face a challenge in making the necessary re-adjustments. However, a large number of the funds in the category are unlikely to be affected significantly.
(c) The AMCs have a lot of options at their end. Investors must watch out on how they react before rushing to buy mid and small cap stocks.
The investors who do not get swayed by market noise are generally the big winners in the long run!
2 thoughts on “Will the SEBI circular on multi cap funds lead to a rally in small cap stocks?”
Very well articulated article. We feel the curtailment of the discretionary powers of a fund manager,that the circular desires may be a precautionary step to guard against any future, non-necesiated exuberance.
Over all it appears that the Regulator is gradually getting in to its role of becoming the driver of the direction that the market may take..in the new normal post covid scenario…
Hi Subrat
Thanks for your observations. Product labelling is important from an investor perspective. I believe that a new category called flexi cap may be a good idea as it will allow every fund house to have a go anywhere fund where the fund manager can completely express their views on equities. Multi cap, as the name would generally get interpreted as a fund that has allocation across large, mid and small caps.
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