New SEBI rules leave Indian MF investors confused

Although the regulator’s new rules mandating portfolio re-balancing for multi-cap funds could broaden the Indian stock markets, they are also illogical, say experts

New SEBI rules leave Indian MF investors confused
The SEBI headquarter in Mumbai. Photo: SEBI website.

(ATF) In a bid to boost the mid-cap and small-cap segments of the markets, India’s capital market regulator Securities and Exchange Board of India (SEBI) last weekend unexpectedly tweaked the investment norms or asset allocation guidelines for multi-cap mutual funds.

To be "true to label", the regulator mandated these funds to invest a minimum of 25% each in large, mid, and small-cap stocks, making the minimum investment in equity and equity-related instruments to 75%. For the remaining 25%, SEBI said that such funds were free to invest anywhere including holding cash.

Sebi has asked the fund houses to comply by January 31.

But while experts have said the move is well-intended for fixing the undue biases of large funds, some have also termed the move “illogical” and said that it is “bizarre”, creating confusion among mutual fund investors and fund managers. But it also threatens to upset the plans of the mutli-cap funds by forcing them to reshuffle over the next few months.

Fund managers also wonder why Indian portfolio investors have been put under tighter restrictions while foreign portfolio investors (FPI) — who are bigger players — are free to invest in any stocks without limits.

The industry estimates that while the FPIs have invested $128 billion in Indian equities, domestic mutual funds’ equity investments stand at $106bn.

Earlier, the minimum investment in equity and equity-related instruments was 65% of total assets and there were no guidelines for asset allocation for domestic funds. That means that such funds had the flexibility to allocate their assets in large, mid, and small-cap stocks as per their discretion.

“The SEBI move is bizarre and another instance of regulatory overreach,” said Amit Mantri, a fund manager at 2Point2Capital. According to Devinder Pal Singh, Chief Business Officer at SBI Mutual Fund, “although the intention is noble, the rules seem to be hurriedly formulated that could lead to an adverse fall out, at least right away”.

“Go-anywhere to can’t-go-anywhere funds”

A multi-cap fund is a type of equity mutual fund that invests in companies across all three-market capitalisation (m-cap) i.e. large-caps, mid-caps, and small-caps. Sebi categorises the top 100 companies in terms of m-cap as the large-cap universe. The 101st to 250th company in terms of full m-cap as the mid-cap category, and the 251st company onwards as part of the small-cap basket.

“Until the new rules, the biggest attraction of the multi-cap funds were that they could go and invest anywhere for best returns so these funds invested mostly in large-cap stocks, which were leading the stock exchange rally over the past two years, “ Dhirendra Kumar, founder of the mutual funds research firm Value Research told ATF.

But adds Dhirendra, the new rules now force these funds to invest in small companies that are inherently much more risky, and aren’t listed in enough numbers to make investments in them worthwhile for a fund manager.

According to Mumbai-based wealth management firm ASK Wealth Advisors, there are currently 35 open-ended multi-cap schemes with a total asset under management (AUM) of $20bn accounting for around 20% of all open-ended equity-oriented schemes. To comply with the guidelines, multi-cap funds will immediately have to sell $4.8bn worth of large-cap stocks and buy $5.55bn worth of mid-cap and small-cap stocks.

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As a perspective, the total free float market-cap (amount of available stocks) of the mid and small cap segments is estimated to be $22bn. In other words, multi-caps funds will need to suck up 25% of the total available free-float m-cap in the market to comply with the proposed limits.

“Clearly, there’s hardly enough mid-cap and small-cap stocks available in the market for the mutual funds to invest,” says Devinder of SBI Mutrual Funds. “Imagine how unhealthy it would be for the markets when billions of dollars chase so few available stocks.”

Disruptive for investors too

If enforced abruptly, there is likely to be a disruptive impact on investors too.

After all, add experts, mutual investors are expected to be passive investors while an important goal of a regulator should to devise rules that ensure the stability of the markets. “But the moment a regulator announces something that creates a flutter and anxiety among investors, I think it takes the industry a step back,” says Dhirendra of Value Research.

Besides, the new rules could end up “in front running as well, which means that fund managers could hoard the small caps and sell them when the prices rise sharply, which is also undesirable,” added Devinder of SBI

Not without merit

Still, with multi-cap funds increasingly chasing large-caps over the past two years, SEBI’s move is not without merit, according to some.

They add that over the past two years, the markets were moved by a handful of over-priced large-cap stocks. And mutual funds, to some extent, may have contributed to this by increasingly chasing expensive large-caps. Consequently, mid and small cap companies were struggling to raise capital which is needed for smaller companies and the economy to grow.

“While multi-cap funds by name and nature should be investing in stocks across market capitalizations, a number of mutual funds were just using the name multi-cap but for all practical purposes were investing mostly in large-cap funds. Consequently, the top large caps were trading at 80 times their price-earnings multiple but the rest of the market was being ignored,” Sunil Singhania, founder of Mumbai-based Abakkus Asset Manager told ATF.

The regulator must be applauded for this move and given credit, he added.

Meanwhile, experts like Pal Singh are also optimistic that SEBI will hear the industry out and make the necessary changes in the rules to make them implementable seamlessly.

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