Immediately, it is quite likely that most mutual funds will impose restrictions on incremental investments in mid-cap and small-cap schemes or even increase the exit load – a fee for early exit – for this category to make hasty redemptions more expensive. But beyond some of these steps, industry executives seem to be at a loss for ideas that could dissuade investors from pumping more money into these schemes or protect their existing unitholders’ investments in the event of a sharp sell-off in smaller stocks.
This regulatory mandate comes after over two months of back-and-forth discussions between Sebi and mutual funds. During these talks, sources said proposals such as the swing pricing mechanism for small-cap and mid-cap schemes, like for debt schemes, were discussed. Swing pricing is aimed at reducing the impact of large redemptions in debt schemes on remaining investors. Industry officials opposed this plan on the grounds that this system would work only for debt schemes.
While some critics are accusing Sebi of adopting an approach that’s tilting towards a ‘nanny state’, few can disagree with the regulator’s unease about the growing risks in these share segments with a flood of money chasing the same set of illiquid stocks. According to a Samco MF study, the assets under management (AUM) of small-cap schemes in January at a record ₹2.48 lakh crore was almost 83% of the AUM of the large-cap scheme category of ₹2.99 lakh crore, as against 44% in August 2021. If such unprecedented flows can propel stocks to new heights, investors must be prepared for the reverse too.
Though there are no signs of the bullish momentum stumbling, Sebi wants mutual funds to be prepared for sharp outflows from small-cap and mid-cap funds. If at all there is a stampede out of mid-cap and small-cap stocks, the magnitude of the sell-off could be crippling. The unpreparedness of debt mutual funds in dealing with the liquidity crisis in the credit market and its chain effect on the financial system not too long ago is a strong enough motivation for Sebi to push mutual funds to focus more on risk management in small-cap and mid-cap schemes.
Mutual fund officials contend that the room to invest up to 35% in the liquid large-caps is a strong liquidity cover. But the fact is that despite growing concerns over small-cap and mid-cap stocks being overheated, many schemes in these categories have still not utilised these limits. This is because fund managers of these schemes are anxious that lower exposure to small-cap stocks will lead to scheme underperformance.A section of the mutual fund industry blames Sebi’s stock categorisation policy for the concentrated mutual fund money flows into mid-cap and small-cap stocks.All listed companies are ranked based on their market cap with the top 100 being large caps, 101-250 being mid-caps and the rest being small-caps. Equity mutual fund scheme categories can only invest as per these prescribed slabs. While fund managers might be justified in their angst about the availability of a limited pool of stocks in the mid-cap space, that’s not the case with the small-cap universe, where the scope is much wider. The issue here is that mutual funds’ internal filters crimp their own stock selection universe. This forces them to channel the money flows into the same set of stocks.
Some senior mutual fund officials are hoping that Sebi’s call for caution in the mid-cap and small-cap spaces may prompt investors to voluntarily stop fresh flows or even redeem these schemes. They do not want the regulator to come up with rules that could affect business. Still, though it’s not Sebi’s mandate to give its opinion to investors about market levels or share valuations, few can disagree with the intent behind the regulator’s stance this time.