Changing Caps In The MF World

A recent decision by the securities regulator came as a mild earthquake for many in the mutual fund industry and a big surprise for millions of investors as multi cap funds are supposed to contain a mix of all three major categories - large, medium and small cap shares.

The bulk of the money in equity funds comes from ordinary investors because institutions and companies usually prefer debt funds. They are also those with the insufficient capability to assess a plethora of mutual fund schemes sold through high-pressure marketing and require a greater protection from the regulator. At stake are funds that are worth at least Rs 35,000 crore.

The Securities and Exchange Board of India (Sebi) found that major Asset Management Companies (AMCs) were investing 70 to 80 per cent of funds in just one category - shares of large and influential companies - allocating very little to other categories. Many agree with the regulator that mutual fund companies are mislabelling the funds as multi cap and thus misleading investors.

“For a long time, I have felt short-changed. I bought multi cap funds but my money was not invested in small and mid cap stocks that often stand a chance of high returns. Fund managers exhibited a clear bias for the big companies,” complains Maheshbhai Patel, an investor from Ahmedabad.

But there are many who are strongly opposed to the new rule. Most large AMCs will be affected and this means a major part of the investors in multi cap funds. The AMCs will be forced to reduce their fund allocation to large cap shares and increase investments in the other two categories. The Association of Mutual Funds in India (Amfi) has asked for relaxation and the market expects some concessions from the regulator.

“This would be hugely disruptive for investors. Anyone who knows the size, liquidity and depth of India’s market for small cap stocks would know there is literally no way these percentages can be put into practice in all but the tiniest of funds,” says Dhirendra Kumar, CEO, Value Research, about the new rule.

“In practice, AMCs which run such funds would either merge them with large cap funds or convert them into other types of funds,” Kumar says.

Retail investors may be at an advantage as there will be some fundamental changes in the manner mutual fund money is invested. The medium and small cap shares, which have very little influence compared to their big brothers in the large cap bracket, will see some unexpectedly brisk sales pushing up their prices. What has emerged is the possibility of better returns with some exposure to the mid and small cap segment without increasing the risk significantly.

“The implications for the investors are very positive and finally investors will get a pure multi cap scheme in the true sense,” says Rushabh Desai, an Amfi-registered mutual fund distributor based in Mumbai. “If re-allocated, the infusion of liquidity in the mid and small cap space will positively impact the returns of all multi cap schemes in the long run. This is because the large cap valuations are already at their peak and the mid and small caps have a lot to catch up on,” he says.

Amfi figures show that the multi cap equity fund category is the second largest one with around Rs 1.46 lakh crore by way of AUM as on August 31, 2020.

Earlier, Sebi rules did not prescribe any limit based on market capitalisation. Funds were allowed the flexibility to invest in any category and they exhibited a clear preference for large caps. The new rule has prescribed a minimum 25 per cent allocation to large, mid and small cap stocks each giving funds the liberty to use the remaining 25 per cent for any category of stocks. The new restrictions come into play on January 31, 2021.

“Some fund managers are already running strategies, which are very close to the new mandate and we expect them to continue doing so. A few other managers who choose to remain in the multi cap category will look to realign their portfolios as per the new mandate over the next few months,” says Kaustubh Belapurkar, Head Fund Research at Morningstar India. His advice to investors is not to react immediately. “They should await further clarity from the asset managers on the intended strategy for the fund. With this information they can take a holistic call on an overall portfolio basis if that particular fund continues to fit into their risk-return and investment time horizon consideration,” he says.

Investors in both lump sum and Systematic Investment Plans (SIPs), should not redeem their corpus or stop their SIP’s from multi cap schemes. New investors in these areas should try to stay away from the multi cap category at the moment and look for alternate categories like focused funds, advises Desai.

In effect, the new mandate will result in a higher allocation of at least 50 per cent to the mid and small cap sectors. This will in return increase the risk in these funds. The small cap companies are more susceptible to revenue and profitability risks in an economic slowdown. Experts say that the shares of small companies will stand a great chance of sliding in a situation of economic uncertainty.

In fact, fund managers preferred large companies precisely because they offered fewer risks than small and medium players. The reputation of funds as steady providers of good returns is based on how wisely they are invested, and managers felt that large stocks would best ensure that. Some fund managers allocate as little as 5 per cent to small company stocks.

“This rule can also lead to creating a new category of dynamic equity or equity flexi cap for investors if Sebi permits, whereby the fund manager will retain his full flexibility to churn the portfolio and investors will have more options to choose from. In this way no one is impacted,” Desai says.

This possibility seemed real on September 22 when Sebi Chairman Ajay Tyagi told members of Amfi, “It is not the intention of the regulator to force the industry to invest in anything. In this regard, Amfi has made its representation, which is being examined actively, and the announcement would be made soon.”

The industry also expects some relaxation and have more time to implement the new rule. Another possibility is relaxation of ratios allowing fund managers flexibility to choose the category of their choice from the present limit of 25 per cent. If the flexible portion is increased, it will mean a decrease in the ratios of the other categories.

Authorities will also have to consider the tax implications. At present, funds with a lock-in period of three years are regarded as Equity Linked Savings Scheme (ELSS) enjoying tax-saving advantage. Many regard them as flexi funds from the investment perspective. The government will have to decide how it wants to treat the new category of funds that will emerge out of Sebi’s new rules.

saibal@outlookindia.com