Decoded: SEBI’s advisory to MFs on small, midcap funds and the practical challenges

Mutual fund body AMFI on February 28 told member asset management companies (AMCs) to take preemptive steps in their mid and smallcap schemes because of the froth building up in these stocks.

The Association of Mutual Funds in India (AMFI) did this at SEBI’s prodding. Among the key things mutual funds have been told to do are to moderate inflows, rebalance their portfolios and ensure that investors who redeemed early did not put the remaining investors at a disadvantage at any point.

Moneycontrol learns that mutual funds have to make certain additional disclosures to AMFI on their small and midcap schemes. These are: 1) risk related to hypothetical liquidation of portfolio during stress time, say, a 10 percent redemption or a 30 percent redemption 2) concentration of portfolio 3) concentration of investors (assets contributed by top five and top 10 investors) 4) portfolio construct between large, mid, small-caps and cash 5) valuation parameters like price to earnings multiple, price to book value and 6) portfolio investment risk metrics like Sharpe ratio.

Also read: Why market got spooked by SEBI advisory to mutual funds to limit smallcap, midcap fund inflows

We spoke to mutual fund industry people and market participants on the proposal. The general view was that SEBI and AMFI were right about flagging the exuberance in mid and small caps. Let’s take a look:

Is moderating inflows into these schemes mandatory?

No. It is up to the fund house. Many fund houses had been doing that. SBI Mutual Fund stopped accepting lumpsum investments as far back as 2020. The biggest of them all, Nippon Smallcap Fund stopped accepting lumpsum investments in July 2023. Only, smaller, newer funds are accepting investments right now.

Will moderating inflows help curb retail investors craze for mid and smallcaps?

Yes and no. The more aware investor would take this as a sign to stay away from small and midcaps but since there will always be some fund houses welcoming inflows, retail investors will head there. That’s not a bad thing because it will keep the market liquid. But prices may get distorted and stocks could continue to get more expensive, diminishing their return potential in future.

What if all mutual funds decide to set a limit for inflows?

They won’t, because mutual funds compete with each other, so smaller funds would want a piece of action if a segment continues to grow. Even if it does, it is very likely that many retail investors would directly invest in small and midcaps, which is even more risky.

Then why is Sebi even doing this?

Because Sebi is concerned about a potential scenario wherein the sentiment turns and there are sudden redemptions which mutual funds are unable to meet. Besides, in such situations, funds may decide to liquidate their most liquid positions and leave the portfolio with illiquid names for which there may be no-takers, which will end up hurting the remaining investors in the scheme.

What does rebalancing of portfolios mean?

It is a nudge to mutual funds to lower exposure to some of the illiquid stocks and increase exposure to the more liquid names. Smallcap funds are allowed to invest up to 35 percent in largecap stocks, which are liquid. Right now, the large-cap exposure for several schemes is less than this maximum limit. Fund managers can increase allocation to liquid stocks.

Also read: Will Sebi advisory on small- and mid-cap funds cause forced selling?

How will that help?

If there is a sudden wave of redemption, the more liquid stocks can always be sold without the price declining too much.

Then why have they not done it already?

Every fund manager does this based on their outlook. Although liquidity is an important consideration, fund managers make investment decisions based on a company’s fundamentals. A more liquid portfolio need not mean better returns. In fact, building a portfolio with liquidity as the main criteria could give subpar returns. On the contrary, a fundamentally good stock can deliver better performance if held for a longer period as its growth pans out.

But aren’t largecaps a safer bet than smallcaps?

The industry has two arguments in favour. One,  quite a few storied largecap names were reduced to penny stocks in the years following the 2008 crash, and are still nowhere near their peaks. Suzlon, Reliance Power, JP Associates, Jet Airways, Reliance Capital and GMR are some of the examples.  Two, many of the smallcaps of that era have gone on to become largecaps today.

Most fund managers seem to suggest largecaps offer great value today…

That’s is true because the biggest constituency of investors in the India markets, thus far, namely the FPIs, have been largely selling stakes.

Since they are big investors in largecaps, stocks in this segment have not delivered as well as small and midcaps where domestic investors are bigger participants. Either way, since most fund houses have separate largecap offerings, they may not like to dilute the focus of their smallcap offerings and let investors make that choice.

Besides, since mutual funds are about long-term investing, churning the portfolio depending on market conditions may not make sense.

Does monitoring quantitative aspects like PE multiples and PB help assess risks?

That is subjective. Quality stocks always trade at high valuations, while stocks of companies with not-so-great fundamentals trade at lower multiples. This does not mean stocks with low valuations will give better returns. Also, the PE multiple can change suddenly, depending on a couple of great quarters or disastrous quarters of earnings. This might give some sense of the style of a fund manager but not a great measure or riskiness of a portfolio.

What about the hypothetical liquidation of the portfolio?

On paper, it is always possible to show that funds will be able to meet redemptions in times of stress. In reality, the impact on the net asset value will depend on the demand for the stocks the fund is looking to sell at that point. During the meltdowns of 2001 and 2008, trading in many stocks was frozen for days on end because of lack of buyers.

How can mutual funds ensure that those redeeming their funds early won’t put others at a disadvantage?

One way is to ensure that there is sufficient cash kept at hand in the portfolio. The other way is to limit redemptions. But limiting redemptions will go against the basic tenet of mutual funds: that they are highly liquid and can be redeemed any time. This is also the reason for Sebi’s advisory action.

So, does the AMFI mandate held reduce risk in this category of funds?

Sebi’s alert definitely sensitises both the industry and investors to the potential liquidity risk but there is only so much of the portfolio that can help in cash or liquid assets. If too many investors come to redeem at once, funds will be forced to sell shares at unfavourable prices. But that is a risk investors have to bear — the risk of price erosion and value destruction in case stocks are overheated and there is meltdown.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.