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

Brightcom Group: The capital markets regulator SEBI has issued a confirmatory order in the Brightcom Group (BGL) case after a detailed investigation of irregularities found in the preferential allotments made by BGL in the financial years (FY) 2019–20 and 2020–21. The regulator has restrained Suresh Kumar Reddy, the promoter-cum-CMD, from buying, selling, or dealing in securities, either directly or indirectly. Further, the regulator has revoked the directions issued against Shankar Sharma, Kishan Prakash, Ishan Prakash, and Shivkrishna Harakchand Damani.

The Sebi advisory to mutual funds to moderate flows and rebalance portfolios is unlikely to create any forced selling in small- and mid-caps that will impact stock prices, leading voices from the mutual fund industry said. This is because most large mutual funds have already been cognisant of the liquidity, as well as valuation risk in the small-cap segments and have orchestrated their individual strategies to deal with the potential threat of market dislocation or redemptions, they said.

Also read: AMFI writes to fund houses citing SEBI directive on froth in mid and small-caps

On February 27, mutual fund industry body AMFI issued a circular based on an email received from SEBI. In a note to mutual fund trustees, the Association for Mutual Funds (AMFI) said that SEBI has advised that given the froth building in small and midcap stocks, mutual funds should put in place a policy to safeguard the investors in these schemes. As a response, AMFI has recommended that this could be done through various means such as moderating inflows into these schemes and also rebalancing the portfolio.

“Mutual funds are creating self-discipline, and this (SEBI advisory) is just a reiteration of that,” said D P Singh, joint CEO, SBI Mutual Funds.

Markets displayed weakness as a result of the note, resulting in a 2 percent fall in both the small and mid-cap indices.

Growing inflows

In 2023, mid cap funds saw inflows worth Rs 22,913 crore and small cap schemes saw inflows of Rs 41,035 crore. On the other hand, large cap schemes saw outflows of Rs 2,968 crore. The BSE Small Cap index and Mid-Cap index have also seen healthy gains over the last six months, with BSE Small Cap index gaining over 23 percent while the BSE Mid Cap gaining over 25 percent.

But, at a broader headline level, there is a lot of concern from a valuation perspective -- if not overvalued, it is richly valued at this time, said Nirav R Karkera, Head of Research, Fisdom. “This has caught the attention of the regulator as well.”

Move in the right direction

“This advisory is an exercise to sensitise people of any future issues (on valuations in the mid and small cap space) so that they are not caught unaware,” said Dhirendra Kumar, CEO, Value Research. Mutual funds have themselves taken measures to address these issues. They have decelerated sales across small cap schemes, he added.

Through this move, Morningstar’s Kaustabh Belapurkar said, they are essentially asking the AMCs to make sure there's a mechanism in place to track how liquid the portfolios are and make sure that they take measures if they feel that capacity and liquidity can become a constraint.

D P Singh noted how SBI Mutual Fund is taking only SIP investments in its small cap fund, and that is limited to Rs 25,000 per month. Several other funds, including Kotak Mutual Fund, have also restricted inflows into their small cap funds recently. In a note to Moneycontrol, Axis Mutual Fund’s Ashish Gupta, said that for them “investor interests are of paramount importance across asset categories”, hence their funds look at not just returns but risk appropriateness of all investments based on investor mandates across product categories including small and mid-cap.

Most small cap mutual funds also have a percentage of their holdings in large caps too. Diversifying the risk further, the universe of small cap stocks in which mutual funds invest has grown substantially. In December 2019, all small cap mutual fund schemes were invested in 347 stocks; in December 2022, this number rose to 429 stocks; and in December 2023, this number was at 508 stocks. So, it has risen steadily, said Dhirendra Kumar.

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