A multi-problem rule from SEBI

Investors of multi-cap funds are in trouble, thanks to a new ruling from SEBI

As most involved mutual fund investors would know now, SEBI has brought in a new rule that will force multi-cap funds to invest very high proportions of investors' funds in small cap and mid cap companies.

As per the regulator, by January 31, such funds should have at least 25 percent of their assets in large, mid and small cap stocks and this is to be done so that these funds are 'true to label'. A multi-cap fund is supposed to be representative of the underlying equity market and if it does not have representation of all sizes of companies then it is not a faithful multi-cap fund.

However, even a cursory examination of SEBI's own definition of large, mid and small cap shows that the 25% limits will lead to a drastic over-representation of mid and small cap companies in multi cap funds. If you apply SEBI's own definition to the equity market, then 74.1% percent of the market's value is in large-caps, 15.6% in mid-caps and the remaining 11.3% in small-caps. If a multi-cap fund is genuinely 'true to label' and representative of the underlying markets, then the limits should be around these values.

Many popular multi-cap funds have very little small-cap exposure. This is as it should be. Multi-cap does not mean all the caps, all the time. As an investor, I expect the fund manager of a multi-cap to do the job of being underweight in segments that are going to do badly and being overweight in those that are doing well. Funds which have very little exposure in small-caps in recent times have done that job well for us investors and should be appreciated for it.

Most importantly, SEBI's new rules would drastically increase the volatility that investors of multi-cap funds would face. Mid-cap and small-cap stocks are more volatile. Now SEBI wants these funds loaded up with far more of these volatile stocks than the underlying markets represent. It's very hard to see what justification there can be for this.

Investors have had a hard time with volatility and uncertainty in recent times. To overload a popular and extremely useful type of fund with volatile and hard to manage stocks is not justifiable, either from a practical standpoint of investor interest, or the principled standpoint of being representative of the underlying markets.