Decoded: MFs that will be most impacted by Sebi directive on small, mid-cap segments

Marker regulator Sebi's advisory to mutual funds to moderate flows and rebalance portfolios is unlikely to result in forced selling in small- and mid-caps but is more likely to impact mutual fund schemes with larger assets under management. According to an analysis by Fisdom, schemes like HDFC Small Cap, Axis Small Cap Fund, HSBBC Small Cap Fund, DSP Small Cap fund and Franklin India Smaller Cos Fund carry a relatively higher risk due to their significant exposure to microcap stocks and limited exposure to large-caps and cash holdings.

Small Cap Funds Likely to Experience Initial Impact

Funds highlighted in red may carry a relatively higher risk due to their significant exposure to microcap stocks and limited exposure to large caps and cash holdings.

Point to note: The Fisdom study was conducted solely to identify which funds might be impacted by the current guidelines issued by the Association of Mutual Funds in India (AMFI), aiming to safeguard the interests of small-cap investors. "It is essential to emphasise that these identified funds are not categorised as poor quality or underperformers. The AMFI advisory specifically addresses mid-cap and small-cap equity schemes, stressing the need for comprehensive disclosures regarding risk parameters on the official websites of Asset Management Companies (AMCs)," said Fisdom in a note.

The Association of Mutual Funds in India has requested fund houses and managers to implement suitable and proactive actions to safeguard investors. This includes measures such as controlling inflows and adjusting portfolios, among others.

Additionally, fund houses have been instructed to adopt measures that prevent early redeeming investors from gaining an unfair advantage.

Factors considered before producing the list are as follows:

1. Higher AUM
2. Less exposure to large stocks
3. Less exposure to cash & cash equivalent(including T-bills)
4. Exposures to stock from Nifty Microcap 250 Index

The Sebi directive comes after the initial round of stress tests on smallcap and midcap schemes with large assets under management (AUM) to see if they can manage huge redemptions in the event of a market downturn. Sebi has recommended measures like putting restrictions on inflows, portfolio rebalancing, and creating a framework to protect investors from the first-mover advantage of redeeming investors.

Some fund houses have already started taking proactive measures to restrict lump sum or one-time investments, aiming to safeguard investor interests as the recent upsurge in market prices of small-cap stocks has led to valuations exceeding the fair value of the underlying businesses. Consequently, assets under management have experienced significant growth. The Nifty SmallCap 100 index has given over 70 per cent return in one year.

Kotak Mahindra Asset Management Company (AMC) has announced restrictions on lump sum investments in its small-cap funds, effective from March 4, 2024.Nippon India Life Asset Management said in 2023 it would no longer accept lump sum investments into the Nippon India Small Cap Fund.  Tata Mutual Fund announced in July 2023 that it would cease accepting lump sum investments and switch-in investments in Tata Small Cap Fund.

Here are some of the corrective measures being taken by mutual funds:

“Both the small-cap and mid-cap segments are in an overbought zone with high euphoria around them. Fund managers are finding fewer reasonable opportunities to invest in. At the same time, the AUM of these schemes has increased heavily and fund managers are finding it difficult to invest in reasonably valued stocks," said Mukesh Kochar, national head of wealth, AUM Capital.

While the invested universe for the mid-cap univese has grown reasonable, the same has grown at a much faster pace for the small-cap cateogry as shown below: 

Are your mid- and small-cap funds under stress?

Following an extraordinary rally in mid- and small-caps last year, investors poured a whopping Rs 63,949 crore into these funds. However, historically, a hit year in mid- and small-cap funds has typically been followed by lukewarm returns by these funds. If this trend repeats, SEBI worries whether these funds can withstand large-scale outflows.

"To mitigate the liquidity risk in mutual funds, SEBI requires mutual funds to perform thorough liquidity stress tests. It is a test to gauge the fund's capacity to sell (or exit) stocks when it wants to without incurring significant losses.Fund houses have also adopted measures such as maintaining cash and debt positions. As of January 31, 2024, mid-cap funds had 3 per cent of their assets in cash and debt, while small-cap funds had 6 per cent. Moreover, only 7 out of 29 mid-cap funds had less than 10 per cent exposure to large-cap stocks (they offer higher liquidity). In contrast, 19 out of 27 small-cap funds held less than 10 per cent exposure to large-cap stocks. Further, fund managers believe that a quality stock can always be sold in block deals, irrespective of the liquidity," said Hrithik Madan of Value Research.

Value Research advises investors to be on the safer side and:

1. Maintain a long-term investment horizon of at least seven years for mid- and small-cap funds.
2. Avoid allocating emergency funds to these funds.
3. Allocate 20-30 per cent in mid-cap and 10-20 per cent in small-cap funds. Rebalance regularly to maintain the desired allocation.