September 12, 2020

Implications of SEBI new guidelines on Multi-Cap Funds

by Solidarity Investment Managers in Equity

SEBI came out with new guidelines last evening where Equity Multi-Cap Funds now compulsorily need to invest at least 25% of their corpus in “Mid Caps” (firms ranked between 101-250 in pecking order of Market Cap) and another 25% in “Small Caps (firms ranked 251 or higher in pecking order of Market Cap).   This needs to be achieved by 31 Jan 2021.

In this note we want to address the following issues

a)      How did SEBI get here?

b)      Our view on this order

c)       What this order means for Small and Mid-Caps in the short term?

d)      What this order means for Multi Cap funds in the long term?

e)      How does this affect Solidarity’s investment stance?

How did SEBI get here?

  • Most Investment products are marketed based on near term performance.  Often, the definition of long term is 1 Year.  Hence, CIOs face immense pressure to chase momentum.  In is not surprising to see funds marketed as “Large Cap Funds” holding Small Caps and “Small Cap funds” holding Large Caps veering far from stated mandates
  • In 2018, SEBI introduced guidelines that mandated MFs to stick with stated Investment objectives – Small Cap funds could not invest in Large Caps and vice versa
  • Fund houses, therefore, launched “Multi-Cap” funds to give them more flexibility.  We believe this is an excellent product as a Fund Manager needs to invest where there is an opportunity and not have constraints.
  • However, Multi-Cap Funds, in aggregate, have ~75% of their corpus invested in Large Caps.   The regulator perhaps feels that most Multi Cap funds are actually Large Cap Funds in disguise and hence the new mandate.
  • The regulator is enforcing the rules as per their interpretation of the spirit of the fund/law.  If you are Multi-Cap, you should be diversified across the market cap pyramid.

In our view, the SEBI guidelines are right in intent but will result in poorer outcomes for investors

  • Small and Mid-Caps are ~ 25% of BSE 500 Market Cap and expecting Multi-Cap MF to invest 50% of their corpus “by diktat” into companies that are relatively lower in share of Market cap and relatively more illiquid is not an Investor friendly move.
  • Flexibility is a key tool in a Fund Manager’s armoury.  A Fund Manager should have the right to have 75% allocation to Large Caps in a “Multi Cap construct”
  • If SEBI wanted to enforce this, funds should have been given significant more time to comply

What this order means for Small and Mid-Caps in the short term?

  • As per JM Financial,  ~ 40000 Cr of additional buying has to be done in Small and Mid-Caps to comply with this order while the market clearly lacks the liquidity to absorb this kind of buying.   Hence, one could see a spurt in Small and Mid-caps in anticipation and through large scale buying
  • However, there are subtleties which need to be thought through. For example, SEBI may relax exposures to Mid/Small Caps in line with BSE 500 Market Caps when the anomaly is pointed out; Fund houses may merge schemes and may prefer to sell out of Small Caps – which mean ironically, some Small Caps could be badly hit.    For example, Kotak Multi-Cap is ~ 29000 Cr fund with ~1% invested in Small Caps.  Which means they either need to buy ~7000 Cr of Small Cap stocks or sell ~300 Cr of Small Cap and merge the scheme with another one. 
  • Net net, we expect higher quality Small and Mid-Caps to benefit

What this order means for Multi Cap MFs in the long term?

  • The long term consequences of this are not favourable for Multi Cap funds as a fund manager should not operate with constraints that will affect optimal portfolio construction.
  • It would be better for MFs to wind up this category or re name the category into one which gives them more flexibility and is right for investors
  • If you own Multi Cap MF, you will be better served allocating the money where it can be invested more flexibly

How does this affects Solidarity investment stance?

  • This order does not apply to us as we operate under a PMS License. 
  • If MFs have to comply with this order by 31 Jan 2021, we believe Solidarity should benefit as ~50% of our AUM at present is invested in high quality Small and Mid-Cap names.
  • We will act to take advantage of actions that will be required by others:

a.       We own many great companies which we know MFs are looking to buy.  Tactically, we may increase our position weights a little bit here.

b.      If large multi cap schemes change their proposition and choose to exit small cap names, prices in these names may fall sharply due to low liquidity. We may look at this opportunity to build new positions where we like the business but the valuations have kept us away and the forced sell off would offer us good entry points

c.       And of course, if forced buying leads to valuations getting euphoric, we will may trim / exit positions to re-allocate where on a rolling 5 year basis we see better outcomes.

  • Medium term, this does not affect the way we invest.