On September 11, 2020; the SEBI did something which could have a very significant impact on the Indian Stock Markets and by doing so has put the Indian Mutual Fund Industry in a spot of bother.
The SEBI has brought out a circular which directs that every Multi-cup mutual fund scheme will have to invest at least 75% of its assets in Equities.
So far so good!
But, here is the part where things get a little messy.
The circular also directs that in case of Multi-cap mutual fund schemes, the fund houses will also have to ensure a minimum investment of 25% of assets each in large-cap, mid-cap and small-cap companies.
Presently, fund managers of Multi-cap mutual funds can invest in any company of their choice.
In this post we discuss how this circular would impact a common investor like you and why we think SEBI has got it wrong this time.
Let us begin by understanding how a Mutual Fund scheme operates.
Mutual Funds pool investor’s money and invest them in the financial markets with the view to earn returns for their investors. Towards this end, the Mutual Fund houses employ professional fund managers, who are experts in the financial markets, to take investment decisions on behalf of investors.
The fund managers have considerable autonomy to invest in a company of their choice, based on their research and knowledge of the market conditions.
Mutual funds typically have schemes ranging from debt to equity or a combination of the two.
Even within equity, a Mutual fund house can have a wide variety of schemes. For example a large cap fund would only invest in large cap stocks with some exceptions. Similarly, there are schemes that invest in mid-cap or small-cap companies.
Top 100 stocks on the basis of market capitalisation are defined as large cap stocks, the 101st to 250th stock – classified as mid cap and the rest termed as small cap stocks.
The current SEBI circular is directed at multi-cap schemes which until now had the freedom to invest across sectors and market capitalisation; based on the outlook of the fund manager.
So what makes us think this SEBI circular regulating asset allocation of Multi-cap Mutual fund schemes is all wrong?
For starters, because it takes away the autonomy of the fund managers and makes multi-cap schemes a lot more risky for the investors.
Typically, a multi-cap fund would have most of their assets invested in large cap and mid cap companies; with only a small proportion of assets allocated to small caps.
This is because small caps are typically considered riskier investments than large and mid cap companies.
Companies that command a higher market capitalisation do so for a reason.
These are typically companies which are established players in the market; have strong balance sheet and the ability to whether storms better than their peers.
To ensure compliance with the minimum investment requirement across the three market capitalisation segment, a multi-cap mutual fund manager would be forced, irrespective of his market outlook, to sell existing investments across the large and mid cap sector to invest in small cap companies.
Further, he has to allocate at least 25% of all new unit subscriptions to small-caps.
Any untimely forced sell-off could lead to losses for existing investors.
But the results could be far more dangerous than this.
All this forced buying has the potential of creating a bubble in the small-cap space.
All this buying by Mutual Funds will push small-cap prices up. Other investors with deep pockets would probably sense this as an opportunity to make some quick money and will buy small caps in large numbers thereby pushing prices higher.
Rapidly rising small cap prices will probably catch the eye of unsuspecting retail investors who would then start buying these shares (which would in all probability be trading above their intrinsic value by now) thus driving prices so high that it starts to resemble a bubble.
When the big investors pull out, prices would crash thereby causing huge losses for both the retail and mutual fund investors.
So, what should you do as an existing investor in Multi-cap funds?
Well there is no need to hit the panic button just yet!
The circular will come into effect from February 2021.
In all probability the mutual fund industry will lobby with the government/ SEBI officials to have the circular rescinded.
Some schemes will probably rebrand themselves to escape the rules.
So if you are an existing investor in multi-cap scheme, talk to your Mutual Fund house to understand how they plan to mitigate the risks arising from the SEBI circular.
Thanks for your time!
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