How SEBI changed the game of Multicap Funds? How will it impact your portfolio?

On 11th Sep 2020, SEBI has issued a new circular for all the mutual fund houses in India. This circular is regarding the allocation of funds within multicap funds category.

Before we get into the detail, let's understand what is a multicap fund?

Multicap fund is a subcategory within equity mutual fund where the fund manager can invest the money across large cap, mid cap, and small cap companies.

But, how multicap fund category is helpful?

For an investor, the ultimate goal is to get a good return on the investment in the mutual fund to fulfill the financial goals. But the returns are always linked with the risk. Here, risk means the volatility in the returns.

For example, the large cap category is less volatile as compared to the mid cap and small cap category because the large cap category invests in the top 100 companies of India.

But at the same time, the return potential is limited in large cap due to the fact that they are already big players in the industry so the growth prospect is relatively low as compared to the mid cap and small cap where the growth prospect is higher than large cap.

But the mid cap and small cap companies are more volatile than large cap. It means, there is more fluctuation in the returns from mid and small cap category.

Hence, ideally, an investor would want to build a balanced portfolio with allocation across large cap, mid cap and small cap. This allocation would vary from investor to investor.

Moreover, sometimes large cap category would do well, and sometimes mid cap or small cap category would give higher returns based on the economic situation.

So as a normal investor, it is difficult to make the right balance between large cap, mid cap and small cap.

To solve this problem, there is a category of multicap where the fund manager would decide the right allocation in large cap, mid cap and small cap based on the market condition. Basically, it would be the fund manager's headache to balance the portfolio to maximize the returns and minimize the risk.

Moreover, as a retail investor if you want to balance the portfolio on your own then you will have to pay tax. For example, let's say you have invested Rs 5 lakh in equity mutual fund, and out of this, Rs 4.5 lakh is in large-cap, and the rest of the Rs 50k is in the mid and small cap. Now, you think that mid cap and small cap have higher growth potential and you want to rebalance your portfolio by moving Rs 1 lakh from large cap to mid and small cap then you would need to redeem your investment in large cap worth Rs 1 lakh and you would need to pay tax on profits.

This is the reason multicap category is very popular in India. I hope it makes sense to you :)

What was the SEBI norm on Multicap fund allocation?

As the mutual fund investment in India is regulated by SEBI, they have made few ground rules. ( You can't play the game without rules )

Earlier, SEBI said that multicap fund allocation should be done with a minimum of 65% allocation in equity funds.

For example, if a particular scheme has Rs 1000 Crore then it has to compulsorily invest a minimum of Rs 650 crores in equity mutual funds. The rest can be invested in debt mutual funds. However, within equity mutual funds, there was no further restriction. It means the fund manager can invest the money across the category of large-cap, mid-cap, and small-cap as per his wish. If he wants, he can invest the entire Rs 650 crore in the large-cap fund.

But now, SEBI has changed the rules of the game! 

What are the new rules?

Now, the fund manager has to invest a minimum of 75% in equity mutual funds instead of 65%. Within 75%, the fund manager has to invest a minimum of 25% in each of the large cap, mid cap, and small cap categories. This change has to be done by the end of Jan 2021.

That's a big game-changer.

Earlier, fund managers use to keep maximum allocation in large cap to avoid the high fluctuations of mid cap and small cap categories. But now, they have to invest money in mid cap and small cap.

What would be the impact of this decision? 

I did my research and here are the results:

Let me first show you the allocation of multicap schemes as of 11th September 2020:


This is the list of multicap schemes with AUM higher than Rs 500 Crore. Moreover, there is "other" allocation within equity funds which I have not considered.

Now, you can see that most of the schemes have a very high allocation in large cap category and very low allocation in mid cap and small cap categories. So, fund managers would have to move the money from large cap to mid cap and small cap categories.

What is the existing allocation in terms of Rs? Let's have a look:


How much would be moved from large-cap to mid and small-cap?

   
A total of Rs 22,997 Crore would be moved out of the large-cap category and Rs 10,010 crore would be moved into the mid-cap and Rs 25,939 crore would be moved into the small-cap category.

Large-cap outflow doesn't add up with mid and small-cap inflow, right?

You don't need to add it. The fund house has additional money that they keep in the "others" category. Example, cash. They can use the money to allocate it into the mid and small-cap.

Now the biggest question - What will be the impact of this move and how will it impact the investor's portfolio?

Do you know what is the total asset under management in the mid-cap and small-cap category?

The mid-cap category has ~Rs 90,090 Crore. And with the new rule, an additional Rs 10,010 will flow into the mid-cap. It means an additional 11% of the money will flow into the mid-cap category.

The small-cap category has ~Rs 47,900 Crore. And with this new rule, an additional Rs 25,939 will flow into the mid-cap. It means an additional 54% of the money will flow into the small-cap category. That's a lot of money!

Hence, in the near future, the mid-cap and small-cap categories are expected to give high returns.

Additionally, multicap category would become more volatile due to the higher allocation of mid-cap and small-cap categories.

Moreover, the good companies in mid and small-cap categories are expected to give very high returns.

The only challenge is - Midcap category can still absorb the additional 11% funds, will the small-cap category be able to absorb 54% additional inflow in the next 4 months?
Are there enough companies in mid and small-cap companies where the fund manager can pump so much money?
Well, these are some questions that are still open and only the time would tell the actual impact.

For now, as an investor, if you have a high allocation in multicap category and you do not want to take the higher volatility of mid cap and small cap segments, you can consider increasing your allocation into the large cap category. But please consult your financial advisor.

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