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

Fall in midcap and smallcap indices explained

Midcap and small cap shares took a beating on February 28, with the respective indices diving around two percent. One of the reasons attributed for the fall was an advisory from mutual fund body AMFI to its member asset management companies, at the behest of capital markets regulator SEBI.

What did the AMFI advisory to its members say?

It said that given the froth building in small and midcap stocks, the Securities and Exchange Board of India has advised that mutual funds should put in a place a policy to safeguard the investors in these schemes.

What are the steps that AMFI has recommended?

AMFI has recommended that among other things, mutual funds should moderate inflows into these schemes and also rebalance the portfolio. Also, it should ensure that investors are protected from the first mover advantage of redeeming members.

Why has this rattled the market?

Moderating inflows could mean restrictions on fresh money coming into mid and small cap schemes. In some way, it was the continuous flow of funds into these schemes that was driving stock prices higher. For example, in the year 2023, midcap mutual fund schemes got inflows of Rs 22,913 crore, and smallcap schemes got Rs 41,035 crore. On the other hand, largecap schemes saw an outflow of Rs 2,968 crore.

How will a moderation in fund inflows impact stocks?

When more investors put money in these schemes, price move up and in turn attract more investors. This creates a self-fulfilling effect because mutual funds have to deploy the money in the market. When they buy stocks, the prices of the stocks rise, resulting in an increase in the net asset value of the scheme. This in turn attracts more inflows, resulting in more purchases and even higher prices.

The same cycle can work in reverse too. When prices fall sharply, some investors may panic and rush to redeem. When the fund sell stocks to return money to investors, stock prices fall, causing the net asset value of schemes to decline. This could lead to more selling by existing investors.

How can mutual funds ensure that investors who redeem first do not cause a disadvantage to investors who stay back?

One way to do this is by maintaining a certain level of liquidity in the scheme. This will help the fund to meet potential redemption requests without having to sell shares at unfavorable prices. Market appears to be worried that mutual funds will try to increase the cash in their portfolio and this could lead to more selling in the coming days.