Problem of depth: Why fund managers are herding around the top 400 stocks?

The issue of liquidity is heightened in the small-cap space where liquidity is usually limited – making it a difficult for investors to exit these stocks.

Across 425 active funds in the market, about 95 percent of the assets under management (AUMs) are invested in around only 382 stocks, statistics from Accord Finance and shared by Capital Mind show.

On why of the 5,000 plus listed stocks, across both exchanges, investments from mutual funds were limited to certain stocks three main reasons emerged:

1.     Liquidity

One key consideration while building a portfolio, according to fund managers, is the liquidity of stocks.

Pankaj Tibrewal, VP and Fund Manager-Equity at Kotak Mutual Fund explains that if you go down the market cap curve, then liquidity is a challenge. As fund managers, if you are looking to build a decent fund, you need market cap depth, which comes only from the top 400-500 stocks, he said.

Also read: Problem of depth: Active mutual fund schemes outnumber the stocks they invest in

The issue of liquidity is obviously heightened in the small-cap space where liquidity is usually limited because of low trading volumes, low float and less popularity of stocks — making it a challenge for investors to exit from those stocks, especially during a challenging market period.

In a conversation with Moneycontrol, Deepak Shenoy, founder of Capital Mind, explained that currently, the largest small-cap fund in India has a corpus of about Rs 37,000 crore and a market cap of around Rs 17,000 crore. So, in such a case, if the fund manager invested even a percent of the corpus in this company, they would end up owning a 2 percent stake. “These companies also tend to have high promoter stake and exit becomes difficult," he said.

2 Return success

Another major driver is about finding stocks with the right amount of profitability. Tibrewal said, “If you look at the concentration of profitability, a large part of the profit pool of corporate India is concentrated among the top 300 stocks. For example, large caps which are top 100 stocks may constitute about 75 percent of the profit pool, mid-caps constitute another 15 percent or thereabouts and then, there are small caps. So, a large part of the profit pool lies in that top 350-400 stocks.”

Sahil Kapoor, Head, Product, DSP Mutual Fund, said this is not something out of the ordinary. “These stocks account for 90-95 percent market cap and profitability. So why would people not look at these companies? This is true not only in India but in most other countries as well,” he said.

3  Regulations

Another challenge some of the fund managers said was due to the SEBI guidelines. Mutual funds are required to make a fixed percentage of investments within their own space. For example, according to AMFI, for multi-cap funds, they need to invest at least 65 percent in equity and equity -related investments with no cap restrictions. For large-caps, at least 80 percent in large-cap stocks, for mid-caps, at least 65 percent in mid-cap stocks and for small-caps, at least 65 percent in small-caps stocks.

Christy Mathai, fund manager at Quantum Mutual Fund said that if you look at the data on active funds, a majority of these will be large-cap funds. So, if you were a fund manager managing a large cap fund, 65 percent of the portfolio will by mandate go into the top 100 stocks as that would be your universe to pick and choose from, he said.

“The only categories where you have leeway to invest are small cap funds, flexi-cap funds and maybe some thematic funds,” he said. This is the reason why they are selective in their choice and tend to stay within the BSE 500.

Under Sebi guidelines, based on market cap, the top 100 stocks are large-caps, the mid-caps are from 101 to 250 and the small-caps begin from 251. For fund managers, this classification has been a guiding principle while investing. Clearly, the 382 stocks that form the superset of companies that mutual funds invest in means that the playing field in small-caps is restricted to the next 150, at best.

Are they ignoring a large market in the micro-cap segment or are unworthy or investments? If one would look at stocks at 504th or 501st position (as of September 2023), HG Infra Engineering and Olectra Greentech, both stocks with market caps within the Rs 5,000 to Rs 5,300 crore range, have seen steady performance over the last five years.

Olectra Greentech, for example, has gained over 400 percent in stock price over the last five years, while HG infra Engineering has rallied over 300 percent.

Also read: Cost or Returns — which is more important as an investor when picking an investment

Kapoor has a slightly different take on this and believes that it is not true that fund managers are not looking at stocks beyond 500. He said, “There is a misconception that stocks beyond 500 are not small caps SEBI defines that all stocks beyond 251 stock are small caps. It is not true that investors are not looking at those stocks. If there are good stocks and they fit the investment strategy then people are investing. I think a lot of fund managers that have an open mind about these companies.”

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.