Transfin.
HomeNewsGuidesReadsPodcastsTRANSFIN. EOD
  1. Reads
  2. Deep Dives

What are SEBI's New Rules for Multi-Cap Funds?

Editor, TRANSFIN.
Sep 18, 2020 7:12 AM 4 min read
Editorial

Recently, SEBI issued a circular that caused quite a stir in the mutual fund industry, targeting the asset allocation rules for multi-cap funds. 

The new rules, it said, would ensure more diversified portfolios, decrease these funds’ exposure to large cap stocks, and make them “true to label” multi-cap in nature.

But First, A Brief Refresher...

Multi-cap funds are mutual fund schemes that invest in large, mid and small cap companies (hence the “multi”!). 

One way stocks can be divided is based on their market cap.

  • The top 100 stocks based on market cap are called large cap stocks. They tend to have a capitalisation of over ₹10,000cr ($1.36bn) and are large and well-known companies, investing in whom is generally regarded as a low-risk endeavour. Think: RIL, Wipro, Axis Bank, SBI, etc.
  • The 101st-250th stocks tend to be mid cap and those from 251st are small cap. These have market cap below ₹10,000cr ($1.36bn) and are relatively riskier to invest in.

Mutual funds can be divided in a similar manner.

  • Large cap funds are those that have invested at least 80% of their total assets in large cap stocks.
  • Mid cap funds invest around 65% of their total assets in mid cap stocks.
  • Small cap funds invest the same share (65%) of their total assets in small cap companies.
  • Funds that have major investments in all three are multi-cap.

 

Why Fund Managers Are Biased Towards Large Cap Stocks

So, even though multi-cap funds are theoretically supposed to have stocks from a wide variety of companies - big and small - fund managers have generally favoured large cap stocks over their mid and small peers. 

Why? Well - they are less volatile, have a longer track record, and are significantly more liquid. Said another way, they offer a superior risk-reward profile with the ability to seamlessly slide in and out of positions.  

And no fund manager wants to see their funds underperform, so they have generally been biased in favour of large cap stocks. 

 

What are SEBI's New Rules for Multi-Cap Funds?

 

But if a multi-cap fund mostly comprises large cap stocks, it defeats the purpose of having a portfolio whose nomenclature hints at diversification by market cap, doesn’t it? 

So SEBI deemed it was time to enforce a change and increase demand for smaller stocks (perhaps another regulatory intervention envisaged to support smaller companies during these turbulent times).

 

What are SEBI's New Rules?

SEBI made two big changes, which will come into effect on February 1st 2021.

One

Multi-cap funds will be required to invest at least 75% of their total assets in equities and equity-related instruments. 

Presently, this number is 65%.

Two

Minimum equity investment allocation rules have been introduced.

  • Minimum allocation to large cap stocks = 25%
  • Minimum allocation to mid cap stocks = 25%
  • Minimum allocation to small cap stocks = 25%

Presently, no such allocation rules exist. It is this minimum allocation requirement that has caused the stir.

 

Does SEBI Have a Point?

The regulator certainly has data on its side. Estimates suggest out of the ₹1.5Lcr assets under management of multi-cap funds, large caps account for roughly 65%, midcaps around 25% and small caps the remaining 10%.

In fact, the asset allocations of some of the top funds are a testament to SEBI’s concerns:

 

 

What Happens Now?

This is certainly not as straightforward as most of the market commentary seems to suggest. 

On one hand, analysts expect as much as ₹40,000cr ($5.45bn) to be reallocated to mid and small cap stocks from large caps. This would mean that multi-cap fund managers have their work fairly cut out for them. They will have to revamp their portfolios and redistribute allocations before the deadline. Under the new rules, exposure to large cap stocks can’t exceed 50%, and at least 25% of assets will have to belong to mid and small cap stocks each. 

This could naturally increase demand for smaller stocks, maybe even at the expense of their larger counterparts. And multi-cap funds that are currently heavily invested in large cap stocks would be forced to trim their exposure to the same, which could even lead to a meaningful dip in some widely-held large and mid cap stocks that have seen a run-up in their prices.

On the other hand, one way fund managers could perhaps continue investing primarily in large cap and mid cap companies is by embracing large and mid cap funds much more than their multi cap counterparts.

By changing the allocation requirements, will the uptick in the cash flowing into small caps offset the downtick in cash flowing into the small caps on account of fewer multi cap funds? That is the question. And only based on how it plays out can one really assess the impact from these new norms.  

At the end of the day, capital tends to chase opportunities that offer the highest possible reward for the risks undertaken!

FIN.

The cut-throat world of Business and Finance means that there is fresh News everyday. But don't worry, we got you. Subscribe to our Wrap Up Newsletter and get commentaries like the above straight to your inbox.