What’s the deal with new multi-cap rule SEBI announced?

Unless you are someone who’s not interested into stock market or have suddenly gone off the grid, there are high chances that you have come across the new “Multi-cap” rule SEBI has announced recently. In a nutshell, it has basically asked all AMCs to strictly adhere to its tag “Multi-cap” (ironically). Ensure that they invest across all segments of companies. So, why was the market, especially small cap aficionados, Gung-ho about this circular? Well, that needs some explanation.

What does Multi-cap mutual fund mean?

We saw about mutual funds before. Multi-cap mutual fund allocates its funds across equities of all market caps : Large caps, Mid caps and Small caps. All AMCs have roughly ₹150,000 crores (source : Value research) worth AUM under the name of multi caps. That’s roughly 20% of all equity funds. Quite simply put, it is a popular category.

What is the Multi-cap rule all about?

SEBI on Saturday (12th Sep,2020) came up with a circular modifying rules for multi caps. Without going too much into the details, let me outline key modifications:

1. Minimum of 75% must be invested on to the equity market

2. Minimum of 25% each must be invested in Large, Mid and Small caps respectively.

SEBI has provided time until January 2021 for all AMCs to adhere to this new guideline issued by them. 

(For people who are interested, stocks are categorized into three caps twice a year by AMFI. AMFI or Association of Mutual Funds India, is “not for profit” association with all SEBI registered AMCs as its members. Calculations for all mutual funds are done based on this categorization. You can find the classification here)

What was the multi-cap rule before?

Prior this rule change, the AMCs actually had it easy. There was only one rule tagged against multi cap funds which is to ensure that at least 65% of fund are in equities with remaining 35% at the discretion of the fund houses. In other words, fund manager can pick whatever company he wants to invest in without having to worry about its size. For all SEBI cared, a multi cap fund can effectively have its entire portfolio with just large cap companies as long as 65% is invested on to the equities.

Why this rule change?

All this changed (or atleast is bound to change) since initial circular of SEBI. Incidentally, they didn’t explain why this change was even brought. But on the latest clarification press release, SEBI has mentioned two clear objectives:

1. True to label: SEBI claims that it has been brought to their notice that many mutual funds do not stay true to its “Multi cap” tag. Their investment is majorly skewed towards “Large Cap”. It doesn’t truly reflect the label multi-cap mutual fund

2. Comparison with an appropriate benchmark: In continuation with previous stated skewed investments, assessing mutual funds against “multi cap” benchmark will be misleading as the fund has major exposure towards large cap.

To sum up, the modification is to protect investors from being mislead by the fund managers. In other words, SEBI wants the investor to get what the label says : A multi cap fund with exposure to companies of multiple capitalization.

Does this matter or simply a technicality?

In a word : Yes, it does matter and no, its not just a technical readjustment. When we at Finlighten, did a quick analysis on biggest 5 multi cap fund the results were a bit damning. All mutual funds have significant exposure in large cap companies. To make things worse, this wasn’t even an outlier, this is actually the norm. The category average exposure of Multi-cap funds towards large cap is at a mind boggling 68%. Meaning they are essentially large cap funds operating as multi cap funds.

Large cap exposure in biggest five biggest multi cap mutual funds are very high in India. Multi-cap rule will impact these funds as they have to reallocate their assets now
Large cap exposure in biggest five biggest multi cap mutual funds are very high in India. Multi-cap rule will impact these funds as they have to reallocate their assets now

What are the potential impact of multi-cap rule?

First and immediate potential based on the above infographics, almost all multi cap funds will have to rejig their entire portfolio. Exposure towards the large caps will have to go down while small caps can no longer be given the dirty eye from multi cap funds.

Secondly, according to business standard, multi-cap schemes currently have investments of ₹96,000 crore in large-caps, about ₹25,000 crore in midcaps and only ₹14,000 crore in small-caps. In the end, this rule might potentially act as a “robin hood” and take money from rich large cap companies to poor (relatively speaking) mid and small cap companies.

Finally, Large caps in India have traditionally commanded a premium owing to their robust business models and size. This premium “might” marginally go down because of micro-cap rule change.

Do AMCs even have a choice?

Of course they do. The initial concerns from market experts and fund managers alike were, what if they don’t find any good stock to invest in small/mid cap. In the aforementioned clarification, the following are the possible alternatives that AMCs have:

1. Reclassify themselves as one of large cap or thematic or focused funds (focused funds can invest in limited set of companies irrespective of their capitalization)

2. Merge multi cap fund with existing equity funds : large cap or focused funds

3. Mutual fund houses can always return the money back to clientele citing this regulatory change and inability to find proper avenue to take in more money or managing the existing ones.

4. Final and most obvious option is to simply adhere to the new rules. Rebalance of the portfolio must be before January 31st i.e, when AMFI announce their half yearly categorization

SEBI has also reiterated that to achieve the desired objective of True to Label and Appropriate bench marking, it will examine proposals of the industry if any. In conclusion, safe to say, this is far from concluded and if you have invested in any multi-cap mutual fund, you have to literally wait and watch.

What this means to the small & mid cap cos?

It is difficult to tell yet as there are potentially 4 options that each multi cap fund manager can choose from. If majority of the players decide to rebalance their portfolio, then good high quality small caps will definitely rally. However…

N.Shah, group president and managing director at Kotak Mahindra Asset Management Company, said in an investor call, according to details shared by the fund house. “We will not buy small and mid cap stocks if it doesn’t make sense for our unitholders, contrary to what is being speculated on street.” They manage the largest multi cap mutual fund in India.

If majority decides to go the way of Mr.Shah, then the likelihood of sector wide rally of small-cap looks remote. Having said that, this might be one of the better times to buy good quality, well run small cap companies as trickle down effect of multi-cap rule will definitely reach these companies first.

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