Why Sebi is worried about small-cap mutual fund schemes

Historically, redemptions from small-cap funds have led to selling spirals and could even spread contagion to other asset classes. (Image: Pixabay)
Historically, redemptions from small-cap funds have led to selling spirals and could even spread contagion to other asset classes. (Image: Pixabay)

Summary

  • Given limited buying interest from foreign investors, small-caps represent a relatively illiquid asset class. As such, the exuberance appears both unwarranted and unsustainable, especially in light of an inevitable market correction

Regulators are always concerned about market volatility, the potential for scams, asset price bubbles, and market crashes. More so just ahead of general elections, when adverse market conditions can be particularly embarrassing.

In recent months, Indian regulators have taken proactive measures: stringent restrictions on unsecured lending by fintechs were imposed earlier and now action has been taken against Paytm Bank and JM Financial.

Markets regulator Securities and Exchange Board of India (Sebi) is also worried. Sebi, in a letter on 27 February, cautioned asset management companies (AMCs) about the continuing inflows in small- and mid-cap schemes of mutual funds even as there is froth building up in these segments of the market.

The word of caution from the watchdog to fund managers about what appears to be orderly market movement is unusual. But Sebi’s concerns are valid.

Mutual funds focusing on smaller companies have consistently delivered double-digit returns over the past five years. Dhirendra Kumar of Value Research has pointed out that for each of the past five years, investments in these funds have increased to one and a half times their original value. As a result, the Nifty 250 small-cap index achieved a 12-month return of 65%, significantly surpassing the benchmark Nifty 50's return of 26%.

Remember, there’s limited buying by foreign investors in most small-cap stocks. In that sense, the market is in a unique situation, as, to use Kumar’s words, there’s a whole lot of exuberance for an asset class that is relatively illiquid. But since no asset class can see a one-way price movement endlessly, a correction is bound to come at some stage.

Sebi's concern centres on the aftermath of an inevitable price correction. Historically, redemptions from small-cap funds have led to selling spirals and could even spread contagion to other asset classes.

Say, fund managers begin to sell small-cap stocks to meet redemption demands from unit holders. The correction in the prices of small-cap stocks that will lead to could trigger more redemption calls, necessitating fresh sales by fund managers, thus creating a repetitive loop. The risk gets exacerbated especially in the case of stocks with low free float, such as small-cap stocks, as they tend to be relatively illiquid. 

In times of corrections, there tends to be no buying side at all in this class. There are bound to be distress sales and extreme price movements then. When the redemption pressures come, fund managers have no option but to first sell whatever they can, which means the illiquid stocks could see a free fall in the absence of a buying side.

There were worries that borrowings by speculators and retail investors were finding their way into small-cap stocks. Inflows into small-cap and mid-cap funds continue even after the lending norms were tightened.

Savvier after previous cycles of stock price run-ups, followed by corrections or at times even crashes, many retail investors have cashed out of small-cap stocks, as Mint has reported.

However, this class of investors still has exposure to small-cap stocks through mutual funds. During April-January FY24, small-cap funds received 37,360 crore worth of net inflows, as against 22,103 crore in FY23 – most of it through systematic investment plans (SIPs). As a result, these funds have become bigger than they ever before.

The regulator, therefore, wants mutual funds prepared for that situation, whenever it may come. It wants funds to institute the steps they plan to take with the aim of protecting retail investors with exposure to small caps through their funds. It has asked funds to formulate and publish this policies on their websites within 21 days.

What options do fund managers have? They may have to set up gates on both inflows and outflows.

There aren’t boundless investible options available to fund managers. If inflows continue into small-cap funds, then fund managers will have no option but to keep investing in the small-cap stocks, affecting the quality of the portfolio. After the nudge from Sebi about the frothiness in valuations of mid- and small-cap stocks with low free float, and the risks this poses to small investors and the broader market, funds in response have started restricting lumpsum inflows, the latest being Kotak Mutual Fund. Some restrictions on the inflows do seem to be the first thing to do.

Second, funds will have to prepare for the “first-mover" sellers, as those could set off cascading loops. No fund will do this unilaterally, but all can agree to clamp an exit load to discourage redemptions. Investors are used to redeeming their investments at will from open-ended funds and so any mutual fund imposing such a charge risks creating adverse impressions. All funds imposing such charges are unlikely to have adverse effects and it could ensure orderly handling of redemptions.

Finally, while fund managers' ability to rebalance portfolios may be constrained by investment caps and the liquidity of their holdings, prioritizing investments in more liquid mid-cap and large-cap stocks could be a prudent strategy.

Needless to say, long-term investors should have no cause to worry about these cycles of ups and downs. They should keep calm and keep investing.

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