SEBI’s new rule on market-caps in multi-cap funds – what it means for you

In a move completely out of the blue, SEBI yesterday issued a circular to define the allocation each multicap fund should have in small-caps, mid-caps, and large-caps. As per this new SEBI multicap rule, a multi-cap fund should allocate 25% each at the minimum to smallcap, midcap and largecap stocks. This is a sea change from the current scenario where multicap funds could have any allocation they wished to, based on their outlook on the market.

We’ll leave the wisdom behind this move for a separate discussion next week. The fact remains that it significantly alters your approach to fund categories. In this report, we will discuss these changes, the multi-cap funds that we have in Prime Funds, and what you should be doing now.

Since this report has many sections, you may go to the section that you are interested in directly, we have indexed it below. You can click to go directly to the section.

Market-cap allocations so far

So far, SEBI’s multicap rule was broad and allowed funds to change allocations to market capitalisations based on opportunities. SEBI’s definition for multicap was simply “a fund investing across large-cap, mid-cap, and small-cap stocks”.

Now, consider the market-cap allocations. In the past year, about 7 in every 10 multicap funds had at least 65% of their portfolio in large-cap stocks. In fact, many multi-cap funds were becoming more firmly oriented towards large-cap stocks.

Of the remaining portfolio share, the bulk of it went to mid-cap stocks. On an average in the past 3 years, the category held about 15-19% in the midcap market segment. Very few had allocations above 25%. With small-caps, it is even lesser, with average holding at less than 10%.

Funds could use their discretion to up or reduce exposure to the riskier market segments when the need arose. For example, the more aggressive multicap funds pushed mid-cap allocations above 20% in mid-2019, and a few have added more here given the steep correction. But virtually no fund has allocated more than 20% to small-cap stocks and even a 10%-plus allocation is not frequent. Why? Because of the steep correction this segment has gone through over the past two years and the far riskier nature of the segment.

We went back see if funds took higher exposure to mid and small cap at some point and found the following: Just 14 of the 36 funds in the multicap category even took to an over 25% allocation to either mid or small-cap stocks – that too sporadically – in the past 2 years. These funds had low AUM and are not among the consistent funds in the space.

Therefore, to fit the new SEBI multicap rule, funds need to drastically alter their portfolios and add to their mid-cap and small-cap holdings.

 The July multicap portfolios (since August portfolios are yet to be declared for all funds) shows the extent of change that funds need to make:

The marketcap segments were calculated based on the AMFI marketcap breakup given last, as of June 2020. Based on July portfolios, approximately Rs  29,000 crore needs to move into small-caps and Rs 11,500 needs to move into mid-caps. Large-caps will see a fall of about Rs 33,000 crore, assuming a 50% allocation to large-cap stocks.

The impact of the SEBI multicap rule

The consequence of the SEBI multicap rule is that it robs multicap funds of the ability to freely allocate to midcaps and smallcaps to manage portfolio risk and balance return with risks. It also removes, to some extent, the differentiation between multicap funds since all need to necessarily have similar allocations.

The SEBI multicap rule changes the following:

The risk-return profile of multi-cap funds will shoot higher

• Since multi-cap funds now always have to maintain 25% each in small-caps and mid-caps, they will become a high-risk category. This is in stark contrast to their current level, where they can suit investors of all types, depending on the fund in question.
• Under the new norm, this category is set to get riskier than the large-and-midcap category. This category currently hold an average 40% in mid and small-cap stocks put together.
• Multicaps will find it hard to contain downsides. Consider the Nifty 500 index. A rough calculation shows that small-cap stocks accounted for 5.7% of the total index market cap, while mid-caps accounted for 16.2%. As multicap exposure is set to be much higher, it will be challenging to contain declines better than the broad market index Nifty 500.
• They can generate much higher returns than the broader market during market rallies, given that they may take on much more mid or smallcap exposure than before. To this extent, it can actually be tricky to find a good benchmark to compare multicap funds to, unless one more index is created for this purpose!

The objective of using multicaps will change

Multicap funds had a role to play in your portfolio thus far. This SEBI multicap rule is set to entirely change that.

1. No longer large-cap substitutes: So far, we have been saying that moderate risk multicap funds – i.e, funds like Kotak Standard Multicap and Canara Robeco Equity Diversified, from our Prime Funds list –cannot be large-cap substitutes from here on. They cannot also be the route to improve returns without taking on too much risk. Please read the section lower down on Prime Funds that are multi-caps.
2. Comparable to large and midcap funds: These funds will become comparable to large-and-midcap funds and pure mid-cap funds. In a portfolio, they will play a role similar to mid-cap funds – and that is to drive returns in exchange for higher risk and volatility.
3. Allocation to your portfolio needs to change: Multi-cap funds cannot also be considered as a standalone category – since they will add to a portfolio’s mid-cap or small-cap exposure, it will become necessary to put mid-cap, small-cap and multi-cap funds together when deciding which funds to go for, to build the high-return component in your portfolio.
4. Category level allocation will no longer be possible. Other fund categories that invest across market capitalisations (like value, dividend yield and focused) will have to be viewed carefully to understand whether and how they need to be included in a portfolio. This will have to be decided based on each individual fund and not at a category level.
5. Past performance irrelevant: Past performance for multi-cap funds now reduces in terms of relevance.

What AMCs may do

The SEBI multicap rule needs all multicap funds to overhaul their portfolios and strategies. Funds have until January to implement the changes. There are a few ways in which funds can manage:

•  one, completely change the portfolio allocations (and strategy, if needed). For funds that are already naturally aggressive, it may not require major changes. For funds that are more conservative, it can involve a big shift.
• Two, shift the multicap fund to any other category that may have lower restrictions, subject to already existing schemes, if any, in other categories of the AMCs.

So how funds will handle the rules and effect the transition is not known at this time.

What to do with PrimeInvestor recommendations

Mulitcap funds are present only in the  Moderate Risk segment of Prime Funds, the following are multi-cap funds. All three are predominantly large-cap based.

Some of the above funds are present in our 5-7 year portfolio, greater than 7-year portfolio and it our NRI-active portfolio.

• Our call will entirely depend on what each fund proposes to do  – whether stick to its category or change category. Once we have clarity on what AMCs propose to do, we will revisit each of our calls/portfolios and give you clear actionable calls. We will be engaging with the AMCs as well as analysing portfolio changes to arrive at the action to be taken.  You can and should wait for us to throw light on this.
• The action you need to take and the portfolio allocations you need to alter will depend on what each fund will do. It is not a one-size-fits-all approach that can be taken at this point. Reacting now without clarity on fund changes will be hasty and lead to unnecessary churn and taxation for your portfolio.
• The best thing to do right now is to wait. Continue SIPs and continue to hold investments you have made so far. As and when we know how funds are adapting, you can move forward with the changes to make. Do not redeem your investments needlessly. One cannot rule out any modification to the rules by SEBI. So it is best not to act in haste.

As of now, our buy recommendations on the funds continue to stand. They also remain part of Prime Portfolios as of now, but we will be reviewing the same once we have more information.

Going by the spate of mails we have got from many of you and the instant social media questions on ‘what will happen to Prime Funds’, we would urge you to not panic and show patience. Changes to a fund portfolio will not be immediate – funds have until January 2021 to make the changes – which gives breathing room to make informed decisions.

And please rest assured that we will keep our subscribers informed on what is to be done. Such a decision shall be a considered one and not one to just provide you with an answer.

Update: With AMCs announcing their plans with regard to their multi-cap funds, please go here where we explain the status for our Prime Funds.

P.S: We will be writing over the next week on the larger impact of such a move for the entire mutual fund investing landscape and more importantly whether you can make some tactical calls based on this move. Stay tuned. Such inputs will be for subscribers only!