Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Mutual Funds

Don’t Buy Smallcaps Because of SEBI Multicap Fund Regulations

Dont-buy-Smallcaps.jpg

SEBI has a new circular which mandates that all multi-cap funds will have to change their allocation to:

  • minimum 25% in large cap stocks
  • min 25% in mid-cap stocks
  • min 25% in small-cap stocks

Now “cap”  = market capitalization. If you sell all the shares of the stock today, how much money would you get? It may be 1,000 cr. or 15 lakh crore. If you rank stocks by this value (market capitalization) then:

  • Top 100 stocks are large cap
  • 101 to 250 ranked stocks are mid-cap
  • The rest are small-cap.

This has generated a lot of excitement because:

  • Oye, what are multicap funds having now?
  • Oh, mostly large caps and very little small caps
  • So they’ll have to sell the large caps and buy the small caps! To get them to 25% each!
  • Abeyaar, there is 25,000 cr. that will have to come and buy small caps
  • So we should all buy small caps and when the mutual funds buy, the price will go up!
  • Now calm the (censored) down because the lockdown is starting to get to you.

What’s the situation today?

As of Friday, there was roughly Rs. 144,000 cr. in Multi-cap funds. Now this is a category by itself, and does not include things like Focussed funds etc. Those are a separate category.

If you look deeper some of these funds have very low mid-cap and small-cap exposure.

 

Multicap funds

The initial thought process is that oh my goodness, so many funds have only focus on large caps!

There’s a good reason why such funds have big large cap exposure.

If you are a fund manager whose benchmark is, say, the Nifty 500, then you have to beat that index. That index itself has over 75% large caps (because it’s also market cap weighted). In fact, if you take SEBI’s own definitions of Large, Mid and Small cap, as of June 2020 – a concept applicable for the next 6 months for classification, out of a total of around 136 lakh crores:

  • Large caps in total are 101 lakh cr. (as of Jun 2020) = 74%
  • Mid caps are 21 lakh cr. = 15%
  • Small caps will be the rest = 11%

If this is the constitution of a total market, then why would a multicap fund have majorly different exposures? You could move things around – and increase one marginally versus the other, but there’s no sense is going to equal weighting all the different buckets.

SEBI has done this, but the data shows that clearly they should be looking at a different set of weights. You might say we need 10% smallcaps, 15% midcaps, but to have 25% in each is a little extreme.

A more sane distribution is: (minimum) 25% Largecap, 15% midcap, and 10% smallcap, for an overall total exposure of 75%.

Why Has SEBI Done This?

It is apparently the concept of “True to label”. A multicap should have representation of all cap stocks, and they were mostly large cap. That’s fine really, because to most investors what multicap means is: The fund manager can choose which cap stocks he wants. You bet on the fund manager giving him a wide rope.

But apparently that’s not what SEBI had in mind, so they set up the sub-limits. This can be fixed through dialogue.

There Will Be No Small Cap “Forced” Buying

No mutual fund wants to buy smallcaps at the mega size. Even SBI Small Cap, a very performing small cap fund, reached about Rs. 5,000 cr. in size and then has stopped new entries.

Think about that.

Then, look at Kotak Multicap. It has nearly 30,000 cr. in assets. If it had to buy 25% of smallcaps, could it? That’s 7,500 cr. in small caps. That’s almost impossible to buy. Kotak Standard Multicap would have to buy 1% of nearly every small cap ranked between 251 and 500, just to meet this goal. 1% of 250 stocks. And that’s one fund.

This is not just impossible. It is downright stupid. Because for one, if they wanted to buy these stocks they would have. Second, any one who expects them to go buy stocks like this, the bottom of the pack, in bulk, is not thinking straight.

This is simply NOT going to happen.

Kotak Standard Multicap would have to buy 1% of nearly every small cap ranked between 251 and 500, just to meet this goal. That is not just impossible. It's downright stupid. Click To Tweet

What will funds do?

Multi-cap funds have to meet this criteria so what can they do?

Kotak held a call and brought up multiple things they can do.

First, they can change the fund to a thematic or other such fund. This is not complex, they just have :

  • Get unit holder’s permission
  • Offer them a 1 month exit-load free period if they want to exit
  • Then change the mandate

Thematic funds don’t have cap-wise restrictions. And you can choose a theme like “ESG theme” where most funds will qualify.

Second, they can merge the fund with a large or large+midcap fund. This is easy too, again, only requires to work with unit holders.

Third, they can appeal to SEBI to create a “Flexi cap” category. That kind of fund will allow the fund manager freedom to move where he wants.

Fourth, they can work with SEBI on changing or deferring the change. SEBI has to listen eventually, but they might not get to have a big change – multi-cap in SEBI’s parlance seems to have a different meaning compared to what people on the ground seem to think.

And By When Does This Circular Apply?

Funds will have to comply with this in Feb 2021. That’s about five months away from now.

In five months, the whole world can change.

Already, many stocks which are classified as “smallcaps” are now midcaps. (If you were to reclassify today) An INDIAMART or a DIXON are already in mid-cap territory. On the other side, Bank of Baroda is now a mid-cap, as are United Breweries and Concor.

These changes will keep happening till December 31, after which AMFI will release the new list in January. That list will qualify for mutual funds for the Jan-Jun 2021 time frame.

(Roughly: Largecaps are more than 28,000 cr. market cap, Midcaps are more than 7,000 cr.)

Plus, by that time, most funds would have changed character, reclassified, merged or otherwise moved differently.

Therefore, going on Monday and buying small or midcaps is a stupid thing. But here’s what is more sinister: This can actually result in a big drop in small caps. Not now, but if people get euphoric and buy small caps.

Why should Smallcaps FALL if people buy?

Smallcaps are notoriously illiquid. People who buy them and have watched them grow, realize that it’s quite difficult to sell in size. Even mutual fund managers will not be able to sell when they want to.

If the retail public gets all excited and buys smallcaps, their price will go up. Because that’s the impact cost – with very little volumes, even a slight amount of interest will take prices up.

If the long time holder sees this much buying interest, and prices go up substantially, they will sell. Disclosure: At Capitalmind, we will also do this if prices go berserk on the upside.

Buying from mutual funds will not come. Because of the factors above.

So there are now these new buyers holding stocks thinking mutual funds will come. They don’t come. These buyers may not know much about the stocks – someone forwarded them an excel sheet with stock names. After a while, they’ll get bored and sell.

And when you try to sell and there are no buyers, what happens to stock prices?

This is why you should not jump up and start buying smallcaps now. In fact, if prices do go up like crazy, watch out even more.

Like our content? Join Capitalmind Premium.

  • Equity, fixed income, macro and personal finance research
  • Model equity and fixed-income portfolios
  • Exclusive apps, tutorials, and member community
Subscribe Now Or start with a free-trial