Will SEBI advisory impact investing strategy of smallcap funds?

The smallcap space over the past few years has hogged the limelight among Indian investors.

The Rs 50-trillion Indian Mutual Funds (MF) industry has started work to meet the March 15 deadline to put up results of stress tests. Over February 27-28, the capital market regulator, the Securities and Exchange Board of India (SEBI) instructed mutual funds to dig deep in their small-cap and midcap funds’ portfolios to gauge how liquid they are and how volatile they are compared to their benchmarks, among many other such indicators.

While fund management teams huddle to fish out these vital numbers, the question is how are fund managers and analysts coping inside their trading rooms. Are there enough good stocks to buy out there, to deploy incremental money? Or will SEBI’s watchful eyes curb their enthusiasm?

The smallcap space over the past few years has hogged the limelight among Indian investors. In 2023, returns from the Nifty Small-cap 250 index went up by 49 percent, while returns from small-cap funds went up by 41 percent on average.

Chirag Mehta, Chief Investment Officer (CIO) at Quantum Mutual Fund believes that flows have gone up significantly into the smallcap space. “Absorbing flows is challenging given the liquidity constraint. Certain pockets have run up quite a lot both from the price as well as the valuations standpoint. It makes sense to make sure that we are not getting on the wrong side of things.”

Meanwhile, fund managers believe that the recent advisories by the regulators would help in better transparency and boost confidence in the industry.

“Globally, all regulators are very vigilant, and they have the fiduciary responsibility of taking care of investors. SEBI is not putting any restrictions as such. There are two aspects to the communication. One is advisory: here they have asked trustees to take steps to curtail risks in small-cap funds, if they wish…and they are free to do so. Next: they are asking for transparency…. how liquid a portfolio is and what is the concentration risk,” said Sandeep Tandon, Founder and CIO, Quant Mutual Funds.

With SEBI’s advisory, there are fears among investors that fund houses may look to curtail inflows into small-cap funds that have continued unabated over the past two years, while some may look at investment strategy change.

According to Mehta, if a fund’s strategy at this point is beyond the capacity that their investment style supports, then it would be prudent to curb inflows into smallcap funds or take other measures to contain risks.

Tandon said that they are looking into the suggestions made by regulators to change strategy. “However, prima facie it doesn't look like we need to change our approach because we manage our risks and liquidity analytics very closely,” he said.

Ashish Gupta, CIO at Axis Asset Management Company, is cognizant of the fact that there are high valuations in certain pockets. At the same time, he highlights that small-cap and midcap funds are allowed a fair degree of flexibility.

“In the sense that the minimum threshold for investments in smallcap and midcap stocks is just 65 percent. This gives us the flexibility to invest in large caps. For instance, Axis Midcap fund has invested about 20-23 percent in large cap companies,” said Gupta.

Additionally, midcap and smallcap funds can also keep a certain portion of their portfolio in cash. For example, Axis Midcap Fund has around 4-5 percent in cash, Axis Smallcap fund has around 8-9 percent in cash. This keeps the portfolio adequately liquid.

“Our funds also have a wide investor base. The top 10 investors in our smallcap and midcap funds would constitute around 1 percent of our total scheme’s investor base. We do not have a concentration of investors,” Gupta added.

Meanwhile, Pankaj Tibrewal, Founder and CIO, IKIGAI Asset Manager, believes that the entire cohort in the small-cap space is not very expensive. “There are opportunities in that space where fund managers can do bottom-up picking. Quality companies are available at reasonable valuations. Within this cohort, there are section that are expensive, as is the case within any market segment. Portfolio managers must avoid places where there is momentum or lower free float. Or where management quality is questionable,” said Tibrewal, who recently left Kotak Mutual Fund after a stellar innings managing its mid-cap fund.

Meanwhile, Quantum Mutual Fund maintains a minimum threshold liquidity of Rs 2 crore average liquidity over the last 12 months to be met for stocks to be part of the portfolio. “Our liquidity criteria aim at being able to enter or liquidate the portfolio stock within 66 trading days with 1/3rd participation on any given day. As per the investment process, we want the entire portfolio or most of the portfolio to be liquidated within 66 trading days. We monitor portfolio liquidity on a monthly basis,” said Mehta.

Smallcap has the widest investible universe. There are 100 largecaps, 150 midcaps, but stocks beyond the 250th spot in terms of market capitalisation come under the smallcap category.

However, because of low liquidity and free float, finding enough investible ideas in this space at a time can be a challenge. According to Tandon, the mutual fund industry is growing at a rapid pace even as the depth and breadth of the capital markets is growing.

“The number of qualified institutional placements, new fund offers, private placements and preferential allotments is growing. The stocks also keep moving from smallcap to midcap and then midcap to largecap zones. The smallcap segment is not growing in isolation, and the macro situation is also in very good condition. There are a lot of investible ideas in the market,” said Tandon.

Gupta also believes that there are enough investable ideas and sufficient supply of stocks in the smallcap space.

“There are block deals that happen periodically. If we look at the total supply (primary markets + secondary) over last 12 months, that has also been significant in the market,” said Gupta.

With bumper inflows into smallcap funds and a sharp rally in the stocks from this space, the assets under management of certain funds have become too large. For example, Nippon India Small Cap Fund has an AUM of Rs 45,894 crore, followed by HDFC Small Cap (Rs 28,607 crore) and SBI Small Cap Rs 24,862 crore as of January end.

There are fears that largecap funds may take a bigger impact from the regulatory supervision.

However, Mehta believes that if a fund is operating within the risk framework that they have set, there is no benefit or loss because of the size.

“The risk starts building when you're exceeding those frameworks, like liquidity or market cap. Then it forces you to move into areas where you are not designed to go. Size would only hamper if you go beyond the tolerable thresholds,” said Mehta.

Meanwhile, Tibrewal highlights that research teams at big fund houses have expended. “This gives them the bandwidth to go deep into more stocks and also a diversified pool of stocks to pick and choose from. A large-sized scheme is also good for investors as it mitigates the liquidity issues, if any. If the fund is staggered across 100-200 stocks, it’s better than being stuck with fewer stocks that might come under pressure in illiquid markets,” he said.

Tandon believes that SEBI’s advisory on smallcap funds will not have any bearing on the broader markets, but it will help in transparency in how funds invest.

Meanwhile, experts suggest that an investor in smallcap and midcap spaces should have at least five years of investment horizon.

“Invest in a staggered manner. We won’t advice investing in smallcap and midcap funds, in these markets, in a lumpsum manner. Because this segment has outperformed significantly over the last 12-24 months. The difference between the last 12-months’ rolling returns of the small-cap index and Nifty 50 index has been among the highest in the history of capital markets. Such large outperformance has been rare,” said Tibrewal.

Be a little cautious because valuations are not cheap.