Home >Mutual Funds >News >Sebi rule on multi-caps brings investors to the drawing board
Shot of a figurine bull and chess pieces (Photo: istock)
Shot of a figurine bull and chess pieces (Photo: istock)

Sebi rule on multi-caps brings investors to the drawing board

First assess why you chose to invest in multi-cap equity funds and reallocate your portfolio accordingly

The Securities and Exchange Board of India’s (Sebi) move to standardize the multi-cap equity fund category has led to a lot of discussions on what it means for the stock market segments and the industry. The move will, however, also impact investors in this category.

The multi-cap equity fund category is the second-largest one by assets under management (AUM) of around 1.46 trillion, as on 31 August 2020, according to data from the Association of Mutual Funds in India (Amfi). The appeal for the multi-cap category lay in the “large-cap-plus" profile of these funds that offered the possibility of better returns with some exposure to the mid- and small-cap segment without increasing the risk significantly.

In Sebi’s mutual fund categorization and rationalization rules of 2017, the multi-cap definition did not prescribe any market capitalization-based limits. While funds retained the flexibility to seek opportunities across market caps, most funds displayed a distinct large-cap bias. This is what Sebi’s new directive—prescribing a minimum 25% allocation to large-, mid- and small-cap stocks each—seeks to correct. Mutual funds have to align their portfolios to these new limits by 31 January 2021.

Sebi has also come out with options for mutual funds. This includes recategorizing the schemes or merging them with existing schemes in another category. Another alternatives that is being explored is the creation of a new flexicap category that will allow the funds to follow a flexible strategy of investing across market caps.

As the industry awaits clarity, investors should chart out their own course of action.

Impact of new rule

What works: The new rule gives investors in a multi-cap fund a better idea of what they are getting into. Unlike the existing format in which schemes may have very different allocations across market caps, now the minimum prescription will make it easier to compare and evaluate the performance of funds.

Investors who felt short-changed by the low exposure to small- and mid-cap stocks that these funds took in the past will see greater participation in these segments that have the potential to generate higher returns. Fund managers will have a 25% leeway to weigh their portfolios towards the segment of the market that they believe will outperform.

“In its current form, there is nothing to distinguish a multi-cap from a large-and-mid-cap or a large-cap fund, which may have around 5% exposure to small-caps. A true-to-label multi-cap will give meaningful exposure to mid- and small-cap stocks for experienced investors with greater understanding of markets," said Saurabh Bansal, founder, Finatwork Investment Advisor, a Sebi-registered investment advisory firm.

“Investors with some risk appetite (balanced to aggressive risk profile) who are proactively looking to invest in mid- and small-caps but don’t want to do it themselves would look at this alternative seriously," he added.

What doesn’t? The higher allocation of at least 50% to the mid- and small-cap sectors will increase the risk in these funds. As a segment, small-cap companies are more susceptible to revenue and profitability risks in an economic slowdown. The stocks see greater drawdowns in a market downcycle along with the risk of liquidity drying up.

“The small- and mid-cap exposure is best left to the discretion and expertise of the fund manager. If a business ticks the boxes on the parameters that managers use to evaluate opportunities, then it should not matter whether it is large-, mid- or small-cap. I wouldn’t want to be in a fund where there are rigid mandates that do not allow for meaningful calibration according to economic and market conditions," said Suresh Sadagopan, founder, Ladder7 Financial Advisories.

The rigid equal exposure to each segment may mean longer periods of average returns in the scheme since a run-up in one segment may be tempered by muted performance in the others.

The need to bring up the allocation in the schemes in the category to the prescribed limits may have consequences on the returns in the near term too. “Funds will be required to invest around 35,000 crore in the small- and mid-cap segments to adhere to the rule and this is likely to be at high valuations. This may affect the performance of the schemes going forward for some time," said Sadagopan.

Evaluate the options

Investors should start with figuring out why they invested in multi-cap funds in the first place.

For investors who saw it as a core portfolio fund with a moderate risk-return matrix, the new multi-cap category does not fit the bill anymore and warrants a relook.

If a new flexicap category accommodates the strategy of the erstwhile multi-cap funds, then they can continue with the investment. If the flexicap option does not materialize and the existing scheme stays in the multi-cap space, investors will have to look for other categories that are closer to their risk-reward preferences. This may include categories like large-cap funds, value funds, large-and-mid-cap funds and even focused funds for investors willing to take additional risk.

The fund house may also decide to merge the erstwhile multi-cap schemes into one of these categories. In this case, too, investors should take a close look at the suitability of the strategy and the risk-return matrix of the scheme into which it is being merged.

The change is good for those who chose multi-cap funds to give their portfolios a healthy dose of the growth possibilities in small- and mid-caps. “I think multi-caps will be taken as a thematic play. Investors may want to use it more tactically in their portfolios to benefit from the more accentuated market cycles in mid- and small-caps," said Bansal.

Investors who want to take the new multi-cap route need to look at their investment portfolios and see how much exposure they have to the mid- and small-cap segments across investments to correctly assess the risk in their portfolios.

“Investors would start comparing the two categories (true-to-label multi-cap with flexicap) more closely. They will start to look for evidence if the fund managers really take the right calls on allocation. The new benchmark index (for true-to- label multi-cap funds) would evolve," said Bansal.

Things to keep in mind

Investors who choose to switch to a different scheme will have to consider the tax implication. But it is not advisable to take greater risk to save tax if investors are uncomfortable with the new avatar of multi-caps.

Investors also need to take a call on how to deal with ongoing systematic investment plans (SIPs) and systematic transfer plans (STPs). “We are suspending STPs into multi-cap funds till there is greater clarity. STPs are done at more frequent periodicity and the sums involved are larger. SIPs, on the other hand, are (usually) for smaller amounts and the deductions, typically, happens once a month and that may not significantly impact the corpus because we are expecting clarity in a month or so," said Sadagopan.

Investors need to make the choices based on their individual portfolios, their comfort with volatility and drawdowns and their investment horizon. If investors find the details too much to handle, this may be a good time to look for the professional advice.

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