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This article is more than 1 year old.

New SEBI rules for multi cap funds may not spark the much hoped-for rally in small caps

Mini

SEBI decides that Multicap funds must truly be multicap - so min 25% in large caps, min 25% in midcaps and min 25% in smallcaps.

New SEBI rules for multi cap funds may not spark the much hoped-for rally in small caps
On the face of it, the new asset allocation rules for multi cap equity schemes announced by SEBI on Friday should send fund managers rushing to load up on mid and small cap stocks, particularly the latter. But not everybody in the market is betting on it, and for good reason.
First, the changes to the rules.
Till now, multi-cap equity funds had to invest a minimum of 65 percent of their total assets in equity and equity-related instruments, without any category limits. Under the new rule, these funds will have to invest a minimum of 75 percent of their total assets in equity and equity-related instruments. Also, the funds will have to invest a minimum of 25 percent of their corpus in each of the three categories of stocks--large caps, mid caps and small caps.
The new rules will be effective sometime during the first week of February 2021.
This was done to ensure that funds followed the 'true-to-label' philosophy. At present,  most multi cap funds are in fact run as large cap schemes. This, according to SEBI is not a true representation of the category's attributes. Take a look at the current distribution of stocks in some of the largest multi cap schemes. Most are overweight on large caps, and have negligible exposure to small caps.
SchemeAUM (Rs cr)Large cap %Mid cap %Small cap %
Kotak Standard Multi Cap2971475181
HDFC Equity Fund197988683
MOSL Multi Cap 35112409053
ABSL Equity Fund1102368275
UTI Equity Fund1098366235
SBI Magnum Multi Cap906375156
This led many analysts to assume that in order to comply with the revised rules, fund managers will have to liquidate their large cap holdings down to 50 percent. I say 50 percent, because it is technically possible for fund houses to have 25 percent of their assets each in mid caps and small cap stocks and the remaining in large caps.
So, if large cap holdings have to be brought down to a maximum of 50 percent, and exposure to mid and small cap stocks has to be raised to a minimum of 25 percent, money will flow from large caps to mid and small caps as fund managers rebalance their portfolios.
Broking firm Edelweiss estimates that this could lead to an inflow of about Rs 12,000 crore into mid cap stocks and Rs 24,000 crore into small cap stocks. This has led many in the market to hope that there could be a massive rally in small cap stocks over the next few months. Market players are divided.
 
However, some experts have cautioned that the new rules could lead to volatility in small cap stocks as they have low liquidity.
Market sources told CNBC-TV18 that at an investor conference call, Kotak Mutual Fund, which runs the largest multi cap scheme in the country, said the industry could explore one of four options.
1 - Approach SEBI to create a 'flexi cap' category which would be driven by the fund manager's conviction. This category could essentially go 100 percent large/mid/small cap or allocate as per the market situation.
2 - A second option could be to convert the current multi cap scheme into a thematic fund like ESG which would mean only very minor changes to the current construct of the portfolio
3 - They could also merge the current multi cap with a large and midcap fund so that there would be no need to increase small cap allocation.
4 - They would also seek an extension of the timeline to comply with the new multi cap fund requirements
A senior AMC executive who didn't want to be named told CNBC-TV18, "It's just not going to happen that fund houses will fuel the small cap rally by being cornered into buying these stocks".
Many other industry veterans also were of the view that opening the floodgates of liquidity to small cap stocks was just not an ideal situation, adding that if mutual funds had to buy small cap stocks, they should be allowed to do so at their discretion.
Interestingly, the Nifty 500 universe itself is split between large, mid and small cap stocks in a proportion of 81 percent, 14  percent and 5 percent respectively. So if the benchmark itself has just a 5 percent allocation to small cap stocks, how could a multi cap fund have 25 percent allocation, as Rajiv Thakkar, CIO of PPFAs mentions in this twitter thread.
If portfolios are to have large, mid and small caps in more or less equal proportions, the Nifty-500 and the BSE-500 indices may not be very representative. Also, the risk profile of such portfolios will be very different from the current one.
It is evident that fund houses won't be falling over each other to buy small cap stocks till there is some more clarity on the new rules. So those hoping to make a quick buck by buying random small cap stocks in the hope of the coming rally better beware.
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