Multi-cap funds and the latest Sebi directive

Earlier, the minimum investment in equity and equity-related instruments was 65 per cent of total assets.

Capital market regulator Securities and Exchange Board of India (Sebi) on Friday, September 11, tweaked the asset allocation guidelines for multi-cap funds in order to diversify the underlying investments of the fund across the large, mid-and small-cap companies and be "true to label".

Here is a quick explainer on what multi-cap funds are and what the latest directive means for the market and fund managers.

What are Multi-Cap Funds?

A multi-Cap fund is a type of equity mutual fund that invests in companies across all three market capitalisation (m-cap) i.e. large-caps, mid-caps, and small-caps. As per Sebi's circular dated October 6, 2017, the top 100 companies in terms of market capitalisation (m-cap) form the large-cap universe. The 101st to 250th company in terms of full m-cap come under the mid-cap category and the 251st company onwards form the small-cap basket.

What has Sebi done over the weekend?

On Friday, Sebi made it mandatory for multi-cap fund managers to invest a minimum of 25 per cent each in small, mid, and small-cap stocks, thus making the minimum investment in equity and equity-related instruments to 75 per cent. For the remaining 25 per cent, the fund manager is flexible (it can include some cash as well).

Earlier, the minimum investment in equity and equity-related instruments was 65 per cent of total assets and there were no guidelines on the quantum of asset allocation. This means that funds had the flexibility to allocate their assets in large, mid, and small-cap stocks as per their discretion. Hence, at present most multi-cap schemes are primarily large-cap dominated (74 per cent of assets under management ).

According to ICICI Securities, multi-cap schemes of mutual funds have an asset under management (AUM) of Rs 1.47 trillion as of August 2020.

The deadline

All the existing multi-cap funds have been directed to ensure compliance with the latest rejig within one month from the date of publishing the next list of stocks by the Association of Mutual Funds in India (AMFI), i.e. January 31, 2021.

The impact

Most analysts expect the move will broaden the equity rally in the markets and small-caps will see significant flows. Edelweiss Securities believes that the move entails a big rejig within multi-cap schemes. To meet this new criterion, they believe, nearly Rs 40,000 crore ($5.5 billion) needs to flow from largecaps to the small-and mid-cap segment (Rs 12,000 crore to mid-caps, Rs 28,000 crore to small caps). They expect the small-caps to see strong price action, as holdings of mutual funds (MFs) in them are low at nearly Rs 50,000- 55,000, crore.

Is rebalancing the portfolio the only option for fund managers?

No, it is one of them. In a press release issued on Sunday, Sebi clarified that apart from rebalancing their portfolio in the Multi-Cap schemes, mutual funds (MF) could inter-alia facilitate the switch to other schemes by unitholders, merge their Multi-Cap scheme with Large Cap scheme or convert their Multi-Cap scheme to another scheme category, for instance, Large cum Mid Cap scheme. READ MORE

What should retail investors do?

It is obvious that the move will entail a sharp rally in the mid, and small-cap stocks. However, investors should tread with caution and focus on companies with strong balance sheets, corporate governance practices, brands, technology, and the ability to withstand shocks, analysts say.

"We note that although mid and small caps have outperformed Nifty since March lows by 8 per cent and 25 per cent, respectively but they still leave a scope of re-rating given drubbing of past two years, says Amnish Aggarwal, head of research at Prabhudas Lilladher.

Short squeeze in small/micro caps is likely given the higher quantum of buying expected and relatively lower supply. The situation in our view, however, remains an evolving one, as mutual funds might explore options to reduce the actual impact, says a note from ICICI Securities.