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How Does SEBI's Multi-Cap Funds Restructuring Directive Impact Us?

It's a blessing for Small-Cap investors. The Small-Cap universe was under-performing since 2018, with some good uptick seen after the Covid crash. This would add even more exuberance, as focus would return to Small-Caps from the mutual fund industry after being shunned for nearly 2 years. Long term retail investors who were reeling negative returns finally can see some light ahead. Fresh liquidity in these counters could lead to a pyramid-ing, with the robin hood traders finding a new vogue. Valuation re-rating for Small-Caps is expected.


For the fund managers and Large-Cap investors though, it's a headache. This latest change in rule has a wide reaching impact in the world of equity markets. Why? To understand that, we need to look at the AUM of Multi-Cap funds, which stands at 1.46 lakh crore rupees as of 31st August data from AMFI. This is second only to the Large-Cap funds which stands at 1.49 lakh crore. It's neck to neck between these categories. It's evident that Multi-Cap is a heavily invested category, hence a restructuring of it would increase the turnover and volatility in the markets. Most funds in the category have a higher exposure to Large-Cap with >70% on average. While, Small-Cap exposure is quite low, <10% on average. To adhere to the minimum 25% exposure to Large, Mid and Small Cap, they have to raise the allocation from <10% to 25%, which translates to 15% of the AUM or more. This means a potential restructuring(Buying) in Small-Cap in tune of 20k Crores or more. Not just that, to achieve the restructuring, the funds have to prune their Large-Cap holdings to 50% or less, translating to 30k Crores or more(Selling) . Needless to say, it has a high impact.


No wonder the fund managers are jittery at this proposal. They have to find high quality Small-Caps that have the liquidity to support such kind of buying. Small-Caps are highly illiquid and with mandated buying, the funds would not find fair value for these stocks and have to shell out a premium. Surely not a happy position to be in. Considering the Pandemic we are in, it is not easy to weigh the potential of Small-Caps also. Safety would be their biggest concern because the economists all over have observed that, it is the small companies which lack deep pockets, will undergo huge stress and recovery could take time. As a fund manager, you wouldn't want to buy a Small-Cap for the sake of restructuring, only to see it battered by poor economic conditions and lose entire value of the investment. Increasing exposure will surely downgrade the risk meter of the funds hugely. The volatility in the fund's NAV will become difficult to digest for some investors who would have invested in these funds by seeing a larger exposure to Large-Cap and limited small cap exposure which can help in out-performance. With the restructuring, these funds suddenly become too risky for investors with moderate risk profiles, ultimately forcing the retail investors to do their own restructuring of mutual fund portfolio by switching to Large Cap funds! So the impact is not just a fund level restructuring, but a retailer restructuring as well. This is an additional headache for the fund managers, because there is potential of some redemption in Multi-Cap funds, which cannot be predicted.


And then the other side of the problem for funds is the forced profit booking on Large-Cap stocks to reduce the exposure to 50% or less. Would they profit book the Top 10-20 stocks on Nifty or the remaining of the lesser performing stocks? This is an unique problem, where they need to take a call of whether to sell better performing market leaders to achieve diversification or to sell the lesser performing secondary Large-Cap stocks which have higher potential to reduce risk. In either case, there would be some amount of selling in the Large-Caps, but could be lapped up by the FII and other Large-Cap funds. Retailers following the same method to restructure their portfolio to take advantage of the new interest in Small-Caps would also contribute to some minor selling pressure on Large-Caps.


But, the fund houses are sure to find different ways to mitigate this problem and avoid churning their Multi-Cap funds. They can remodel or merge their fund as a Large and Mid-Cap fund or a Focused fund, to avoid the restructuring. That would also safeguard the interests of the existing investors by remaining true to their risk profile. Smaller funds can even think of closing their fund to start fresh after they understand the retailer's pulse. So, SEBI's direction might not lead to a large scale restructuring as well. As far as the Large-Cap funds are concerned, they could see some subdued performance as long as the Small Caps outperform and form a bubble. So mutual fund investors need to wait and see what strategy the funds take, to make a decision.


In hindsight, it makes us wonder if the restructuring is part of the reason why we saw DII being Net Sellers in the Cash Segment for almost every day since August beginning. SEBI says this directive is aimed at safeguarding retailer's interest. In reality, it is anything but that, because, with this restructuring, the risk profile of the investor gets altered involuntarily for the worse and not for the best. But for the listed MSME sector though, this is a lifeline. This is in line with the Govt's push to support liquidity for MSME. The restructuring is bound to bring in a gush of liquidity in these stocks which would surely be cashed-in by the promoters of the companies with stressed balance-sheets. Whether the liquidity will be used to improve their business or used to provide exits for promoters, depends on the quality of the management. Hence SEBI needs to protect investor interests by curtailing operator trades in these counters. Instead of providing a stable platform for retailers, this could probably lead to another bubble, this time in the Small-Cap space. Hence it becomes important for direct equity investors to be highly vigilant while investing in Small-Cap.


Surely we must ride the initial tide by participating in the Small-Cap rally. Why should we miss an opportunity to participate and take a piece out of the pie? But we should be careful with the quality of stocks we choose and the exposure to it. Prompt exits should be made when the tide signals a retraction. Avoid stocks with high debt and promoter pledge, even though daily upper circuits entice you. Keep a watch at bulk deals and promoter offloading to be vigilant.Volatility in Small-Caps would increase, hence it is not everybody's cup of tea. So keep true to your risk profile. Direct equity investors can look at booking some profits in the Large-Cap counters in anticipation of flat to negative performance in the short term until the confusion subsides and the restructuring is complete.


So there could be some correction on Nifty in the near term, thereby leading to minor correction on the broader market as well, as the funds continue their Large-Cap pruning. At the same time, pockets of quality in Small-Cap are likely to rally whenever a correction on the Nifty concludes, as funds try to find value in the Small-Cap space.


 

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