Previously multicap MFs were loosely defined as those who merely invested 65% of assets in equities, resulting in skewed market allocation; but will it help small cap stocks ultimately?
Multicap mutual funds, which hitherto enjoyed the blessing of a loose ‘at least 65% equity investment’ definition, have just heard the screws being tightened on them. On Friday evening, regulator SEBI in a major announcement directed the second-biggest equity fund category to have a minimum 25% investment each in largecap, midcap and smallcap stocks.
The move, which was also accompanied by widening the at least 65% equity investment window to at least 75% equity investment window, is expected to make multicap funds more true-to-label as many schemes were virtually operating as largecap funds with close to 70-80% largecap stock allocation. Expect funds to make strategy changes as they shuffle portfolios to adhere to the new norms. This is because barring one, no other multicap fund as of now complies with the new rules. The only silver lining is there is some time to make those changes. In this article, we will go through the key changes and try to assess the impact on multicap funds.
There are 35 multicap funds that managed assets of Rs 1.47 lakh crore. From an asset perspective, this makes multicap funds the second largest. In contrast, 29 largecap funds manage assets worth Rs 1.49 lakh crore. When SEBI reclassified fund families, multicap funds received the blessing of being loosely defined. To be a multicap fund, an equity scheme needed to just have a minimum of 65% assets in equity & equity related instruments. Compare this to largecap funds who had to have a minimum of 80% in largecap stocks, large & midcap funds need to have 35% each in largecap stocks and midcap stocks.
With the September 11 announcement, SEBI has changed the rules of engagement for multicap funds. From now on, multicap funds will need to keep a minimum 75% investment in equity & equity related instruments. The bigger directive is of having minimum 25% investment each in largecap, midcap and smallcap stocks. “All the existing Multi Cap Funds shall ensure compliance with the above provisions within one month from the date of publishing the next list of stocks by AMFI, i.e. January 2021,” SEBI said, giving some months to implement the portfolio changes.
Most multicap funds have low to reasonable portfolio turnover ratios. This will change soon as fund managers go on an over-drive to rejig portfolios to comply with the new norms. The portfolio turnover ratio indicates the extent of change in the investment constituents.
Also, do remember that for those multicap funds that had an inherent bias towards largecaps, were likely less volatile. That will change as they stock up at least 25% smallcaps, while allocating more room to midcaps to meet the 25% midcap norm. As a rule of thumb, largecaps are the least volatile. Midcaps are more volatile than largecaps. Smallcaps are more volatile than even midcaps. The 25% allocation to smallcaps, while looking good on paper, entails a higher risk for the strategy since smallcap stocks have notoriously less liquid counters (aka trading volumes) than their bigger counterparts, slowing exits.
Due to their erstwhile generous definition, multicap funds knowingly or unknowingly had become more of largecap plays. They shunned midcap and smallcap exposure to a large extent. Just eight multicap funds had double-digit percentage of exposure to smallcap stocks. In fact more than half of multicap funds individually had less than 7% exposure to smallcaps. Multicap funds have been much more open to midcap exposure with about half a dozen having the necessary 25% minimum midcap allocation.
On a cap-curve basis, the average largecap stocks exposure of all the 35 multicap funds is at present 70%. The average midcap stocks exposure is just 16%. The average smallcap stocks exposure is about 8%. The rest is cash. Now, to adhere to the minimum 25% each in midcap and smallcap stocks, many of the so-called multicap equity funds would have to either hope for fresh inflows that would be all allocated to midcap and smallcap stocks, or lower largecap stocks exposure and channelize that money into midcap and smallcap stocks.
On average, multicap funds would have to boost midcaps exposure by 900 basis points and raise smallcaps expsoure by a whopping 1700 basis points. 1 basis point is equal to 0.01%. These are massive changes, which will impact the portfolio strategy change.
At a fund level, there are just five multicap funds with atleast 25% midcap exposure as per latest data. And, there is just one multicap fund with atleast 25% smallcap exposure. Remember new norms direct multicap funds have atleast 25% each in largecaps, midcaps and smallcaps; Do you know how many funds qualify for that today? Just one.
“….a fund which is maintaining high large cap or small cap exposure in a multicap will be most volatile. As per today’s allocation, most multicap funds have less than 10% small cap exposure. Some even 1%. All the changes need to be made by January 31 based on mcap classification list of 31 Dec. This has 2 immediate ramifications… (A) multicap funds which have less than 5% allocation may decide not to do this big churn and close the fund (b) if the churn does happen, small and mid caps are likely to see increased buying while large caps will see selling leading up to 31 Dec,” says Amit Kumar Gupta, portfolio manager, Adroit Financial Services.
Market experts expect lot of buying in midcaps and smallcaps, but largecap stocks will be sold. “We estimate smallcaps will see Rs 22,000-25,000 crore buying, midcaps will see Rs 15,000 crore buying while largecaps will see corresponding selling. Many schemes will again go for name change etc to reduce impact,” says an investment professional at an insurance company.
Amit Matri, Fund Manager at 2Point2 Capital PMS, tweeted: “…It may look like small caps benefit from this. But in the long term, small caps will be hurt the most.” “This is because many of the larger multicap funds will just change their classification to Large & Midcap and cut even the little smallcap exposure that they have. Difficult for a fund to operate under such inflexible criteria.”
Using data on largecap, midcap and smallcap stock allocation for multicap funds, we can see which funds will have to run harder to comply with the new norms.
The bigger the multicap fund in asset size, expect more the number of investors to experience the changes that the fund portfolio may witness.
Motilal Oswal Multicap 35 Fund, Axis Multicap Fund and HDFC Equity Fund are big funds with over 85% each in largecaps. Similarly, Franklin India Equity Fund, ICICI Pru Multicap Fund and SBI Magnum Multicap Fund have more than 75% each in largecaps.
Even the largest multicap fund, Kotak Standard Multicap has very little smallcap exposure which has to be hiked substantially.
We expect that Parag Parikh Long Term Equity Fund and Nippon India Multi Cap Fund are better-placed than others in terms of portfolio changes, as per data.
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