Mid & small cap mutual funds: Regulators took these 4 steps to protect investors from high valuations

As per AMFI data released for January 2024, the number of folios for mid-cap funds has reached 1.33 crores, and for small-cap funds has reached 1.78 crores. In comparison, the large-cap fund folios stand at 1.33 crores. The assets under management (AUM) for mid-cap funds have reached Rs. 2.90 lakh crores nearing the Rs. 2.99 lakh crores AUM for large-cap funds. The AUM for small-cap funds at Rs. 2.47 lakh crores is not far from that of large-cap funds.

The investment frenzy of retail investors in mid and small-cap funds in the last few months continues as markets reach new highs. It has concerned market regulator SEBI, and it has now initiated steps to protect retail investors in these funds. Following SEBI’s instructions, AMFI has asked the Trustees of AMCs to frame a policy to protect the interests of investors.

So, what are the steps that AMCs are taking or have been asked by SEBI and AMC to take to protect retail investors? Let us discuss some of them.

Trustees of AMCs to frame policy to protect the interests of investors

AMFI has asked the Trustees of all AMCs to put in place a policy to protect the interests of investors in mid and small-cap schemes. Trustees have been asked to frame the policy in consultation with the Unitholder Protection Committees of the AMCs.

The policy should contain appropriate and proactive measures to be taken by AMCs and fund managers to protect investors, including but not limited to moderating inflows, portfolio rebalancing, etc. The policy has to be approved by the Trustees and disclosed on the AMC’s website within 21 days.

Moderating inflows into mid and small-cap funds

As per reports, SEBI has asked AMCs to take steps to restrict fund flows into mid and small-cap mutual fund schemes. While there is a deluge of inflows in mid and small-cap schemes, fund managers are finding it difficult to deploy the money due to the high valuations of individual companies.

As a result, some AMCs have already initiated steps by putting a cap on lumpsum/one-time and SIP investments. AMCs like Tata, Nippon, Kotak, etc. have already put some restrictions on investments in some small-cap schemes. Some other AMCs may also take steps to restrict the inflow of funds in the mid and small-cap schemes in the coming days.

Disclosure of risk parameters and stress tests

AMFI has asked AMCs to disclose risk parameters related to mid and small-cap mutual fund schemes on their website. It includes information on how long it may take the scheme to fulfil any large redemptions, the impact of large outflows on the portfolio value, how much cash level the scheme is maintaining to handle the redemption requests, etc.

There is no SEBI regulation on how much cash the AMC needs to keep to meet redemption requirements. Usually, schemes keep up to 5% of the scheme assets in the form of cash or liquid assets to meet redemption requests.

However, what if there is a big fall in the stock market, and suddenly many investors put in redemption requests at the same time? In such a scenario, the scheme may have to sell shares which may lead to a further fall in the share prices and thereby impact the scheme NAV adversely. The liquidity in small-caps is usually low compared to large-caps. Hence, with stress tests, SEBI wants fund houses to be prepared for any eventualities.

Portfolio rebalancing

A mid-cap/small-cap fund has to invest a minimum of 65% of its total assets in the equity shares of mid-cap/small-cap companies. The remaining money can be further invested in mid-cap/small-cap shares with some allocation to large-caps, liquid assets, cash, etc.

With portfolio rebalancing, the mid and small-cap schemes can increase their holdings of large-cap shares and cash/liquid assets. During big market falls, large-caps usually fall less than mid and small-cap shares. Also, to meet redemption pressures, large-cap shares can be sold easily as they have higher liquidity compared to mid and small-caps.

Why are SEBI and AMFI taking these steps?

In the last 1 year, the Nifty Smallcap 250 Index has given a total return of 63.75% (data as of 31st January 2024). Similarly, the Nifty Midcap 150 Index has given a total return of 55.19%. Looking at these eye-popping returns, investors are pouring money into mid and small-cap funds. As a result, the valuations of the mid and small-cap indices and individual companies are high.

Global events like wars in Ukraine and Gaza, inflation and interest rate movements, election results in India and other major economies, etc., can lead to higher volatility in stock markets. Any sell-off in the broader markets can lead to huge redemption pressures on mid and small-cap funds. SEBI and AMFI want to ensure that these funds are prepared for any such scenarios. They also want to protect the interests of retail investors, and hence they are taking these steps to safeguard them.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.