SEBI made a BIG change in Multi Cap Funds – What should you do now?

September 2020

4 min read

 

Yesterday evening, i.e. on 11th September 2020; the mutual fund regulator SEBI came out with a circular that is going to change Multi Cap Funds completely. According to the new circular; Multi Cap funds now need to have a minimum of 75% exposure to Indian Equity stocks. Earlier, the exposure for Indian Equity stocks had a minimum limit of 65%. Additionally, SEBI also defined exposure to large, mid, and small-cap stocks. As per the SEBI’s circular,

1. The minimum investment in large cap stocks should be 25%.
2. For the mid cap stocks, the minimum investment should be 25%.
3. The minimum investment in small cap stocks should be 25%.

All the funds will have to comply with these norms by January 2021. At the outset, this may seem like a small change; however, there will be a major impact on some of the big Multi cap funds. We will look at this change and the actions you need to take.

Multi Cap Funds – Existing Portfolio Breakup

Multi Cap funds have been a very popular amongst fund managers and advisors for one main reason. The fund managers had complete freedom to take exposure across market capitalization. Due to this, it was easier for the fund managers to play to their strengths and generate alpha over markets. However, with this, a lot of multi cap funds became large cap heavy; due to the volatility in Mid and Small Cap stocks.

Here’s a portfolio breakup of top 10 multi cap funds with market capitalization:

As you can see, in all the top 10 funds, the exposure to large cap stocks is very high and exposure to Small cap stocks is very low. Now in order to comply with the new SEBI norms, funds will have to sell the large cap stocks to buy Small cap stocks. The rationale for this new change in Multicap funds is to make the funds “True to Label”. The Small cap stocks have liquidity issues and high volatility, a lot of fund managers took very small exposure to such stocks. As the funds were heavyweight on large caps, they were not truly multi cap funds.

But this change comes with its pros and cons. Here’s why:

Pros and Cons of change in Multi Cap Funds

Let’s start with the Pros first:

1. The Multi Cap Funds are now actually multi cap with a minimum of 25% invested in all three market cap at all times. This will make funds comparable with each other and the fund managers’ skills in terms of stock selection will be put to test.
2. This move will also benefit pure mid and small cap funds as the significant exposure from Multi Cap funds will move to Mid and Small cap stocks that will lead to an increase in stock prices of these stocks.
3. The Multi Cap funds are now more suitable for long term goals since they have become high risk high reward funds.

Now let’s look at the cons:

1. One of the primary reasons for Multi Cap Funds’ overperformance over other categories is the open mandate to invest across the market. But with these restrictions, Fund managers will not be able to navigate across stocks based on their market views. This will result in short term underperformance
2. We may see a fall in large cap stocks as the multi cap funds will have to sell their large cap stocks to increase mid and small cap exposure. This will have a reverse impact on other categories with high large cap exposure.
3. Even though there is a scope for Mid and Small caps to go up, liquidity and quality of the company are major restraints in stock selection. The liquidity in small cap stocks is very low and can adversely impact the fund performance during volatile times.
4. The risk in multi cap funds will increase multifold and hence they may no longer be suitable for conservative or moderate risk profiles.

Can Fund managers do something to avoid this change?

Some of the fund houses can change the fund category from Multi cap to Large and Mid cap to avoid undergoing this change. For example, Parag Parikh Long Term Equity fund has about 30% exposure to US Equity stocks. They can change the fund category to follow the existing fund management style.

However, this option is not available to every fund house. Because according to regulation,  the fund houses must have only one fund in each category. Hence, if they already have one fund each category, they will have to comply with the new norms by next year.

What should you do with your Multi Cap Funds now?

As of now, you need not do anything with your Multi cap fund. Even though this is a big change, do not take any hasty decisions. One thing to closely monitor now is the fund house communication with respect to this change. Every fund house is now studying the impact of the circular and coming out with the optimal solution. Hence, right now, the best thing to do is to wait and see how the fund houses are planning to change their portfolio.

While the risk in the fund will increase; multi cap funds were anyway used to invest for periods of more than 5 years. Hence even though this change may lead to short term volatility, over the long term the returns will get normalized. We at Investica are tracking every fund in this regard and you can reach out to our team to get more detailed insights for any of the funds you hold.