SEBI’s regulations on multicap funds: the power of compounding errors!

SEBI’s new rule on defining the investment universe for multicaps appears to be a case of attacking a straw man. And it opens up the debate of what problem the regulator is trying to solve for mutual fund investors.

Much has already been said in the last 2 days about the risks of funds trying to fit into SEBI norms and the quantum of small-cap stocks they need to buy.

We’ll therefore stick to giving our view purely from an investor’s perspective and the difficulties that an investor will be put through if this norm goes through, partly or fully.

Many of us who have worked closely with investors know the following:

• Investors want simple solutions
• Investors want least taxation
• And above all investors want great returns.

And needless to say, from a regulatory perspective, they want to be protected, and be provided a fair deal.

Let us put the present circular through these filters to see what purpose it achieves.

Simplicity – or the lack thereof

The multi-cap category is perceived as a go-anywhere fund with flexibility to shift across market capitalisation to generate returns for investors. The 2018 categorization norms allowed for it unambiguously. While one cannot boast of great performance for this category (as has been the case across mutual funds), it housed some good funds that not only showcased consistency but also managed to contain volatility even better than large-cap funds.

Investors also chose this category to play the market – like a Nifty 500 in the passive space. After all, the Nifty 500 has 78% in largecap stocks, 16% in midcaps and 6% in small caps and multi cap funds largely reflect that

Post SEBI’s new category definitions in 2018, it appeared that this category was next to large-cap funds in terms of relatively lower volatility and risk. Investors also chose this category to play the market – like a Nifty 500 in the passive space. After all, the Nifty 500 has 78% in largecap stocks, 16% in midcaps and 6% in small caps and multi cap funds largely reflect that.

Multicap funds were part of most investors’  moderate equity risk segment of holding. And with time, multicap funds, focused funds and value funds when mixed well in a portfolio, were beginning to be better substitutes for the languishing actively managed large-cap space. And remember all 3 categories were large-cap tilted, given the nature of their strategy or style. The 3 put together, offered a good mix of different styles of investing.

This status worked well to build clearly defined portfolios for investors, although the large and mid-cap space remained  a motley group with varying styles and market caps.

The large & midcap category (with min. requirement of 35% in midcaps), with more aggression than multicaps, was considered as a tamer version of pure mid or small-cap spaces – suitable for investors who could not stomach much volatility in the pure plays.

SEBI’s new circular is not only pushing the multicap segment closer to the large & midcap category traits, but is also set to land a maze of complexities in an investor’s portfolio;  key among them will be the heightening of portfolio risk.

However, this has not been an easy category for investors to understand as each fund has a  different risk profile as the market-cap exposure significantly varies. And it houses funds that were earlier midcaps and multimaps, thus carrying over their own legacy traits even now.

For example, Nippon India Vision, a large/ diversified equity fund earlier, had an average 30% exposure to mid and small-cap stocks in the last 2 years compared with the popular Mirae Asset Emerging Bluechip (earlier a midcap fund) that had an average 40% exposure. These variations meant that it was not easy to decipher risk.

Now, the SEBI’s new circular is not only pushing the multicap segment closer to the large & midcap category traits, but is also set to land a maze of complexities in an investor’s portfolio;  key among them will be the heightening of portfolio risk.

Upping portfolio risk: The new circular right away ups the risk profile of a multicap fund if the fund decides to change its marketcap holding to suit SEBI’s circular.

 For example, if an investor had 30% of his/her equity holdings in largecaps, 40% in multicaps (which are large-cap tilted) and 30% in mid and small-cap funds – the investor’s overall exposure to mid and small caps would at best be 30-35%. This immediately  zooms to 50-55% at least, with the new rule.

And if an investor already has a large & midcap fund as well as a multicap and mid and small cap funds, imagine the shift in the risk profile of such a portfolio!

For a new investor, it gets even more complex, trying to figure the investing trait of each fund in this category (and large and midcap) and arriving at his/her overall mid and small-cap allocation in the portfolio!.

For a regulator that insists on risk profiling an investor to ensure that each investor is given the right asset and category allocation that suits his or her risk profile/needs, it appears to be oblivious to the risks that it is directly triggering to an investor’s portfolio through such classification. In fact, managing portfolio risks is what much of investment management is all about!

And this is not the first such change in classification that is set to cause hassle to an investor. SEBI’s 2018 categorization had several limitations that caused investors to suffer due to poor classification or complexities in classification. Some of which are as follows:

• The debt fund categorization leaves much to be said. It allowed credit risk (even now) to creep into categories (low duration, ultra short, and short duration) that were essentially meant to be low risk and liquid. No embargo on credit or liquidity in these categories led to events such as closure of some of the debt funds in Franklin India.
• Creating complex categories such as hybrid balanced, hybrid aggressive, hybrid balanced advantage/dynamic asset allocation and hybrid equity savings. Many of these are opaque structures that are ripe candidates to conceal risks – whether from mid or small cap or from credit risk instruments and lack clear distinction in terms of strategy for an investor.
• Lack of understanding of the risks in hybrid has also meant mis-selling them as ‘income yielding’ options under their dividend plans – until such time the taxation structure for equity put an end to such mis-selling.

Taxation for what?

There is nothing wrong for an investor to seek products with best post-tax returns and also save themselves the hassle of churning and paying taxes, where possible. In its ‘clarification’ note on September 13^th SEBI states the following:  

“SEBI would like to clarify that Mutual Funds have  many  options  to  meet  with  the  requirements  of  the  circular,  based  on  the preference  of  their  unitholders.  Apart  from  rebalancing  their  portfolio  in  the  Multi  Cap schemes, they could inter-alia facilitate switch to other schemes by unitholders…”

Now, this statement, while appearing to indicate that SEBI is open to change, is rather shocking in its tone of suggesting that investors can simply switch to other schemes!!! Why should an investor do so and incur taxes? Did an investor bargain to take higher risks when they entered this category and should they pay a price for SEBI’s notion of a fund ‘not being true to label’?

Yet again, this is not the first time that SEBI is unmindful of the consequences of its actions on investor’s cash out flows. When the SEBI category was introduced, funds changed drastically across categories – to fit themselves in to SEBI’s ideal buckets.

Here are just a few examples:

• SBI Magnum MIP Floater became a multi-asset allocation fund.
• Reliance NRI Equity became a balanced advantage fund and
• ICICI Pru Indo Asia Equity, a fund with exposure to Asian and Indian stocks, became a small-cap fund!

Many advisors had to resort to changes to their investors’ portfolio to ensue that their risk profile and return expectations do not undergo a sea change. And result – taxation. If this were a one-time exercise it is understandable.

But if this were to repeat itself, especially without any reason, an investor has the right to question his/her fund manager and the regulator!

 Tomorrow, a value fund or a focused fund or a hybrid could see change in its attributes due to new diktats! Why this micromanagement? What problem does this solve for investors?

Need returns – period

I am used to hearing the above statement from HNIs as well as retail investors. A fund is expected to perform and deliver. At the end of the day, mutual funds are slaves of the market. As long as they work within their mandate and try generate returns, no investor is going to complain.

Multicap funds did not break their mandate to deliver. The Nifty Midcap 150 and the Nifty Smallcap 250 fell by 45% and 61% respectively from early January 2018 (their peak) and the lows of March 2020. Needless to say, it is large caps that delivered and multi-cap funds stuck to that marketcap segment by and large. No investor is complaining if their fund managers delivered, by sticking to large caps!

Let us look at where investors have reposed their faith among the categories in equity.

• Multicap funds has the highest number of folios next to large-cap and ELSS schemes in the entire equity and hybrid category with 95 lakh folios.
• It has the second highest AUM managed across active equity and hybrid schemes at Rs 1.46 lakh crore of AUM as of August 2020.

The above size talks of the popularity of this category of funds and their acceptance among investors as a category to fit their multiple needs. One does not see a need to disturb that and cause churn to such a large corpus!

 Another unintended and disastrous consequence of this circular can be retail investors going behind small cap companies to make short-term returns now! At PrimeInvestor, we have received plenty of queries in just 2 days on what opportunities lie on this front for ‘tactical returns’! While asking investors to think long term, SEBI’s move may well endanger investor wealth into either stocks or even small cap PMS options (that are rejoicing at this circular) without knowing the risks.

Disturbing trends

The present circular is also disturbing at different levels.

That it was released out of the blue without any consultative approach is rather shocking.

That a regulator decides what an investor needs is distressing.

That it has taken to ‘prescribing’ to fund managers than watching their ways is disconcerting.

That AMCs refuse to unanimously speak for the investors is unsettling.

Unless regulators and manufacturers of MFs in India move from a dos and don’ts approach to a path for innovative, efficient, low cost products that suit Indian investors, the wisdom of the investors shall and will prevail in time.

For starters, categories such as the new multicap, the large & midcap, a majority of hybrid funds and a majority of debt funds will likely go redundant. A combination of passive funds to go with the market and selective, simple, clearly defined fund categories would become the new way of investing. For those who want complexities, you will be better off spending time with expert level sudoku puzzles than figure out re-re-categorizations.  

At PrimeInvestor, we will strive to navigate you through these troubled waters and onto safer shores.

More coverage from PrimeInvestor on this topic:

• What should investors in Multicap funds do now?
• Is there an opportunity in the smallcap space now?