SEBI's new rules for Multi-Cap Funds

The Securities and Exchange Board of India (SEBI), in its circular dated 11th Sep 2020, called for a material change in Multi-cap funds' portfolio structure. The reaction to this circular from the Mutual Fund Industry was mixed, with some praising while others were opposing the new rule. Therefore, SEBI came up with a clarification two days later, explaining the asset allocation structure change in Multi-Cap funds.

Today, we will discuss the new SEBI rules for Multi-cap funds and how they were perceived by the asset management companies (AMCs). Further, we will also discuss the top Multi-Cap funds that are likely to be impacted, along with the statements of what investors are likely to do.

SEBI rules for Multi-Cap funds before new announcement

Multi-cap funds are simple structures with one condition applying for all. They needed to have a minimum of 65% of assets invested in equity all the time. This means that the fund managers were free to decide how much of the assets were going to large-cap, mid-cap, and small-cap companies.

Now, in the above sentence, we talk about large-cap, mid-cap, and small-cap companies. Hence the question arises of what they are? SEBI defines large-cap companies as those that rank from 1st to 100th company in the Indian stock exchange concerning the market capitalization. Mid-cap companies are those which are ranked from 101 to 250, and small-cap companies are those that start from 251st ranged companies.

Before the proclamation of the new rules by SEBI, the flexibility of choosing how much to invest in large, mid, and small caps was primarily decided by the fund managers. The main reason behind it was the power of making an optimum investing decision.

What are the new SEBI rules?

SEBI came up with two significant changes in the multi-cap funds. These rules are discussed below:

1. Minimum allocation of equity is now 75%

As we have discussed above, the only condition applied to the multi-cap funds was that 65% of their money should be invested in inequities. But as per the new condition, from now, at least 75% of the assets in multi-cap funds need to be invested in equities all the time.

This change will not be a significant issue, as Multi-cap funds are mostly investing in equities. The best example is the biggest fund, Kotak Standard Multi-cap Fund, which has 97% of its assets invested in equity. So, this is not the central concern to the investors and the asset management companies.

2. Defined minimum allocation in each market capitalization

This rule spun by SEBI is one that is the daunting concern for everyone.

Before the announcement of this rule, the fund managers were free to choose where they'd like to invest. There was no restriction on how much they were investing in large, mid, or small-cap companies.

As per the new rules dated 11th Sep 2020, all the Multi-cap funds need to invest at least 25% of their portfolio in each market capitalization category. This means 25% needs to be invested in each category - large, mid, and small-cap companies adding 75%.

Concerns raised by SEBI in its clarifications

1. Lack of diversification

SEBI, in its clarification, raised concern over non-diversification. It said that Multi-cap funds invest over 80% in large-cap stocks. The share of small-cap companies is in the lower single digit in some of the top schemes.

2. Divergence and nature of the schemes

From SEBI's perspective, the scheme's name and the scheme's nature are totally at opposite ends, mainly misleading. For example, the HDFC Equity Fund and Kotak Standard Multi-cap fund have 88% and 76% holdings in large-cap funds.

3. Using a proper benchmark

The SEBI has laid many benchmarks that the Multi-cap funds use and are not in line with these schemes. This is because NIFTY 50 is the right benchmark for large-cap funds, whereas Multi-cap funds have the benchmarks of NIFTY 200 and NIFTY 500.

How did the Fund houses respond to SEBI's observation?

As soon as the guideline was introduced in the market, fund managers took on to twitter to calm investors. All the fund houses gave different statements after the clarification of SEBI. Let's discuss it on a more critical note.

Argument replies in lack of diversification

Fund houses feel that the primary reason for opting multi-cap fund is their flexibility in moving between the capitalization category. This is done on behalf of present market conditions, future market outlook, and valuation.

The fund houses say that objective of the Multi-cap fund is to build long-term wealth. This is majorly done by using tools like having a mixed composition of large, mid, and small-cap funds in the portfolio.

Also, in the last three years, large, mid and small caps have moved a lot. For example, small and mid-cap companies were grossly overvalued in the last quarter of 2017, lost 20-30% in the next 12 months. In addition to this, many large-cap companies are overvalued now as the NIFTY Price to Earnings ratio moved to approximately 32.

The argument on the appropriate benchmarks

We already know that multi-cap funds use Nifty 200 or the Nifty 500 for the benchmarks. So, let us understand more about it.

NIFTY 500

The Nifty 500, in terms of large, mid, and small-cap stocks, has a market capitalization composition of 78%, 17%, and 5%, respectively. Now SEBI wants these funds to be distributed equally in multi-cap funds in an equal ratio of 25%. This, in other words, is going against the own words of SEBI for having an appropriate benchmark.

On behalf of the divergence, fund houses say this to another issue as well. Both SEBI and investors might be viewing "Multi-Cap Funds" from different ends. SEBI looks at it as the component of funds. In contrast, the investors look at it around the flexible nature it carried.

HOW WILL THE TOP FUND SIZES SUFFER DUE TO THIS?

Following the composition of large, mid, and small-cap stocks, the top five multi-cap funds by AUM (Asset Under Management) are:

These are the composition of the top five best fund houses in the multi-cap fund. If you scrutinize correctly, you will learn that most of these companies have many assets invested in large-cap funds. To comply with the new SEBI rules, the regulator has given a hundred-day time to analyse and correct their portfolio.

In contrast, shifting such huge capitals from large-cap to mid-cap and small-cap funds is a hasty job to complete. Also, the fund manager complains that this rule will compromise the safety of investor's money.

Fund houses have always used multi-cap funds as an alternate version of the large-cap fund for better security and lower risks. However, with the exposure of matching mid and small-cap funds, the risk might increase. However, the volatility of the returns will eventually be of higher returns.

Although, in its clarification, SEBI also hinted at some of the options available with the fund houses. Here are the two-paramount availability of options they can use.

1. Rebalancing portfolios by adding to small and mid-cap and divesting form large-cap stocks.

2. Merger of Multi-cap schemes with another scheme like a large-cap scheme or large and mid-cap schemes.

"All the existing Multi-Cap Funds shall ensure compliance with the above provisions within one month from the date of publishing the next list of stocks by AMFI, i.e., January 2021," the SEBI guidelines said.

However, according to the fund houses, it is unlikely that they are willing to make these changes. The main reason behind it is the plethora of change they need to make, which is not easy to pull out. Also, it will change the risk-return profile of the funds, which is not a good sign.

What options do AMCs have?

Assuming the high-risk investor's portfolio will have in small-cap companies, AMCs have a few options to introspect before deciding.

1. AMCs can shift to a new category.
2. Merge with another scheme or rebranding their existing Multi-cap funds with other funds like Focused Funds, Large Cap Funds, Value Funds, etc.
3. Wait for more updates on AMFI's request to SEBI for introducing the new Flexi-cap category.
4. Recategorization of market capitalizations.

However, experts think that if the fund houses' decisions do not suit the risk profile of Multi-cap fund investors, such investors should exit those funds.

How will the new rule impact investors?

The new SEBI rule on the multi-cap fund will impact investors in terms of risk. The multi-cap fund was loved because of its flexibility to move between capitals. With the equal investment required in all three caps, the multi-cap funds will increase their portfolio risk because of a large percentage of small-cap stocks.

Not only that, but these funds will also eventually reward with high returns as compared to the amount they receive today in the long term.

Closing Up

To summarize your reading in short, the SEBI has changed the primary condition required for multi-cap funds to work. The former 65% equity allocation is now increased to 75%, which is not major trouble for fund houses and AMCs. However, the other initiative brought by the SEBI is the equal ratio of investment in large, mid, and small-cap funds, i.e., 25%.

This came as a surprise to most investors and resulted in both criticism and praise. SEBI clarified the reason behind these changes are mainly because of the lack of diversity, nature of the scheme, and no line of the proper benchmark.

Fund managers came up with their claims and countered. The rule's primary concern is the deadline (January 31st, 2021) SEBI has given to fund houses to comply with their portfolio. With central stacks invested in large-cap funds, it will not be easy to divest and invest in small and mid-cap funds. Even if they do this, it will turn the risk-return profile, which is not suitable for some investors.

Altogether, AMCs have a variety of options to consider, like recapitalization or merging different schemes. The rule is liable to have a lot of long-term impact on investors and how they look at multi-cap funds. However, if you are an investor, it will be wiser to wait as of now and let the news sink in between different fund houses so that they come up with an alternative.