Should Sebi-defined mutual fund categories be recalibrated?
4 min read.Updated: 12 Jan 2020, 10:02 PM ISTNeil Borate
The Securities and Exchange Board of India (Sebi) is reportedly considering expanding mutual fund categories. Neil Borate asks four experts if there is merit in recalibrating the existing Sebi-defined categories
The Securities and Exchange Board of India (Sebi) is reportedly considering expanding mutual fund categories. At present, large-cap companies are defined as the top 100 by market capitalization, mid-caps as those whose market-cap ranges from the 101st largest to the 150th, and small-caps as those below the 150th largest company. However, some experts argue that the narrow definitions have constrained the ability of mutual funds in certain segments such as large-caps to generate an alpha. Neil Borate asks four experts if there is merit in recalibrating the existing Sebi-defined categories
There is ample room for funds to move across market caps
In its October 2017 circular, Sebi defined the floors and caps for each mutual fund category based on market capitalization. There is enough room for a fund to straddle across and within market caps. A large-cap fund has to invest a minimum of 80% in top 100 companies, which leaves 20% of the portfolio to be invested across large-, mid- and small-cap stocks. Similarly, a small-cap fund has to invest a minimum of 65% in small-cap stocks, leaving 35% to be invested across capitalizations. The large-cap basket of top 100 stocks ranges from a market-cap of ₹8.63 trillion to ₹0.26 trillion. The difference between the smallest large-cap and the largest mid-cap stock is just about ₹700 crore. The difference between the smallest mid- cap and largest small-cap is just ₹16.6 crore.
The fund categorization is well understood among investors over the past two years and portfolios have been aligned as per their risk profiles. Any changes will require a re-alignment as the investment risk and volatility in returns will increase with expansion in the number of stocks in a category.
Rajeev Thakkar, Chief investment officer, PPFAS Mutual Fund
Minor tweaks can make categorization work better
For an asset management company (AMC), it is more profitable to run five schemes of ₹5,000 crore each rather than running one scheme of ₹25,000 crore. Given this, many mutual fund schemes were launched regularly and there was hardly any difference between the new and existing schemes from the same fund house. This created a veritable zoo of scheme offerings. Also, a large-cap scheme from one fund was not comparable to a large-cap scheme from another fund.
Scheme categorization was to address these issues. But it has been blamed for things like fall in the stock prices of small- and mid-cap companies, under-performance of some schemes, fund flows to a narrow list of stocks, lack of flexibility for fund managers and so on. Some concerns are valid in terms of forced churn due to stocks coming in and going out of, say, the large-cap list. Maybe some grandfathering clause can be incorporated where if a stock at the time of purchase was an eligible investment, it need not be sold just because it moved out of that list. Minor tweaks may make operations better.
Tarun Birani, Founder and director, TBNG Capital Advisors
Long-term investors will benefit from expansion
Earlier, every fund house had its own parameter to classify schemes as large-, mid- or small-cap. In 2017, the capital markets regulator came up with regulations on categorization and rationalization of mutual fund schemes.
I feel categorization needs to be dynamic keeping in account market realities, as exemplified by the current market in which too much money is chasing too few stocks. For example, in the large-cap mutual fund category, 80% of the investments are limited to the top 100 companies, a space which is not reflecting the broader market and economic conditions. Very few large-cap funds have been successful in beating the index returns, mainly due to the concentrated rally.
Expansion of Sebi categories will help large-cap funds to generate outperformance (or alpha). Also, some small-cap names will shift to the mid-cap category, which will bring liquidity in the same as well as more choice for fund managers.
Overall, expansion in Sebi categories will be a positive move for investors in the long term.
Do we want price discovery to depend on the perceptions of fundamentals or on fund flows and categorization in market-cap ranks? If investors chase the past year’s returns and fund managers are directed to buy a bunch of stocks, what does one expect beyond sharp polarization? Categorization requires capacity constraint on the size of the funds to be managed in the large- and mid-cap spaces. If this categorization has been decided after funds have attained a size that is sometimes more than the ideal capacity, the impact of the restriction will get compounded further.
Also, we need broader definitions to decide a universe. It could be defined in percentile terms of market-cap like stocks contributing up to 70th percentile to be named large-cap, the next 20 mid-cap and so on.
Lastly, in India, many sector leaders and brands are in the ₹4,000 crore to ₹20,000 crore market-cap range. Why deprive mid-cap mutual fund investors by restricting the flow in this space out of the mid-cap universe and direct it into an unfettered small-cap universe?