SEBI New Rule on Multicap Funds Asset Allocation (Sept 11, 2020)

How SEBI Move on Multicap Funds Will Impact Investors & Mutual Fund Industry?

Introduction

According to the SEBI new rule, Multicap Funds asset allocation rule changed. How SEBI move will impact investors and the overall mutual fund industry? Lets decode the revised rules of multicap funds and their implications in this article.

SEBI New Rule – Multicap Funds Asset Allocation Rule Change

Big Announcement : SEBI Circular on Asset Allocation of Multicap Funds

• In a circular published on September 11, 2020, the market regulator SEBI has modified asset allocation rules for multicap mutual funds.
• According tho the SEBI circular, Multicap Funds will have to keep minimum 25% in Small Cap, 25% Mid Cap and 25% Large Caps.
• Thus, SEBI has directed mutual funds to re-jig portfolios of multicap funds to ensure they are true-to-label.

Re-categorization & Rationalization of Mutual Funds (Oct-2017 Circular)

• Earlier in October 2017, SEBI had issued the guidelines regarding categorization and rationalization of Mutual Fund Schemes.
• What are Multicap Funds?
  • As per that definition dated Oct-2017, the Multicap funds are the diversified equity mutual funds investing across large cap, mid cap and small cap stocks.
  • And the minimum investment in equity and equity-related instruments was 65% of the total assets. There was no other regulation by SEBI on market cap allocation (across large cap, mid cap and small cap)

SEBI New Rule on Asset Allocation of Multicap Funds (Sept-2020 Circular)

• In order to diversify the underlying investments of Multi Cap Funds across the large, mid and small cap companies and be true to label, SEBI decided to partially modify the scheme characteristics of Multi Cap Funds.
• Minimum investment in equity & equity related instruments : 75% of total assets in the following manner :
  1. Minimum investment in equity & equity related instruments of Large
     Cap companies – 25% of total assets
  2. Minimum investment in equity & equity related instruments of Mid
     Cap companies – 25% of total assets
  3. Minimum investment in equity & equity related instruments of Small
     Cap companies – 25% of total assets
• Note :
  • Large Cap Companies : Top 100 companies according to the market capitalization
  • Mid Cap Companies : 101 to 250
  • Small Cap Companies : 251 onwards
• Thus, earlier there were no restrictions in allocating money across Large cap, Mid cap and Small Cap stocks.
• Now, SEBI has directed that – for a multicap fund, there will be minimum 75% exposure in equity with minimum 25% in each Large, Mid and small cap category stocks.
• Mutual Fund houses will have to comply with these new norms by January, 2021.

How SEBI Move on Multicap Funds Will Impact Investors & Mutual Fund Industry?

Implications on Mutual Fund Industry

• According to the SEBI’s earlier categorization rules of mutual funds Oct-2017, there were no limits on how the fund manager can allocate the corpus of the schemes across market caps. The only requirement was 65% minimum allocation to equity.
• This gave the fund manager’s the freedom and flexibility to structure their portfolios, depending upon their valuations of the market environment.

Why Multicap Funds are currently loaded with High Large Cap Allocation?

• Currently, the Multicap Funds seem more like a large cap schemes. Thus, the multicap category was running as a pseudo-large cap category, with almost around 65-70% allocation in large cap stocks.
• While fund managers inculcate the virtues of long term investment, they have to take into account market realities as well. If the large cap category is the flavor of the season, not having adequate exposure to those stocks will cause a fund manager’s portfolio to underperform.
• Large cap stocks are doing well at the moment. Thus, the fund managers are backing large cap companies right now because they feel the stronger and bigger companies are better placed to weather the fallout of the ongoing COVID-pandemic.
• We know as the AUM of a fund increases, the fund manager tends to go heavy on large caps. The reason for this is their higher liquidity and ability to handle sudden in or outflows.

SEBI’s View on Multicap Funds of Asset Allocation Change

• SEBI is of the view that the majority of the multicap funds have high exposure to large cap stocks and are not investing enough in mid and small cap stocks.
• Thus, in order to diversify the underlying investments of multicap funds across the large, mid and small cap companies and be true to label, SEBI decided to partially modify the scheme characteristics of multicap fund.
• Mutual funds have time until Feb 2021 to comply with this rule. Although there is no immediate disruption, this rule will make multicap mutual funds significantly more volatile.

Implications on Investors

• With this latest ruling, fund managers are going to face for a fresh set of challenges. Because they would now have to re-calibrate their portfolios. and need to buy enough mid-cap and small-cap stocks and cut their large-cap holdings.
• Back of the envelope calculations show that fund managers would have to sell roughly Rs.40,000 Cr worth of large-caps and distribute the same to mid and small-cap stocks. This will put tremendous buying pressure on small-cap counters. It would result into the rising demand that is expected for shares of small-sized firms. Thus, small and mid cap stocks are expected to see rally in coming months due to higher buying from mutual funds.
• As a result, the investors who have adequate exposure to small and mid-cap stocks might exit multi-cap funds as many of these would now invest sizably in such companies.
• Some fund houses could even apply for re-classifying their existing multi-cap schemes under another category, to avoid wide re-shuffling of the portfolios.
• One more negative-effect of this rule would be on those schemes that also invest in international equities. For example- Parag Parekh Long Term Equity Fund. Here, the Multi-cap funds that have international allocation will not be able to increase it to more than 25% of the portfolio.
• Singular cases of outperformance, where the one fund alone doing better than the rest, will reduce. So it is definitely a good move for potential future investors in the multicap space.
• Existing multicap investors must bear the higher volatility and extended periods of poor returns if the mid and small cap segments alone underperform.
• We can say SEBI’s new rule would be a good move for the investors. Even though fund managers will lose the flexibility to allocate among large mid and small-cap stocks, investors will finally get a pure diversified multi-cap portfolio.