SEBI, Multi-Cap Funds and Investors
A circular issued by the capital market regulator, Securities and Exchange Board of India (SEBI), on September 11, 2020, states that multi-cap funds need to allocate at least 25 per cent of their portfolios in large-cap, mid-cap and small-cap stocks each by February 2021. How will this impact the mutual fund industry and, in particular, the investors? DSIJ presents detailed insights into what is and what will be
On September 14, 2020, the BSE Small-Cap index jumped by 5.3 per cent whereas the BSE Mid-Cap index was up by 2.6 per cent. On the following day too, the respective indices were up by more than 1 per cent. Frontline indices such as Nifty and Sensex that represent large-cap companies were up by less than 1 per cent in the same period. One of the reasons for such outperformance by the broader indices – represented by the small-cap and mid-cap indices – was a circular issued by the capital market regulator, Securities and Exchange Board of India (SEBI), on September 11, 2020. According to the circular, multi-cap funds need to allocate at least 25 per cent of their portfolios in large-cap, mid-cap and small-cap stocks each by February 2021.
If it is implemented the way it has been proposed, it will lead to huge buying in small-cap and mid-cap stocks and hence we saw a sharp surge in these categories of stocks with investors pre-empting the buying of these stocks, including the mutual funds. To fully grasp this action we need to understand the multi-cap fund category, its size, current allocation and the quantum of buying that one would expect in small-cap and mid-cap stocks.
Current Status
Currently, multi-cap funds need to have minimum of 65 per cent of the assets invested in equity and equity-related instruments and are free to invest across market capitalisation. Going by the current allocation, at the end of August 2020, of all the schemes falling under the multi-cap category, a majority of the corpus was observed to be allocated to large-cap stocks. Allocation to mid-cap and small-cap stocks comes a distant second and third respectively. On average, 35 multi-cap funds at the end of August 2020 had an allocation of 70 per cent to large-cap stocks, 17 per cent to mid-cap stocks and 8 per cent to small-cap stocks. Nonetheless, there are funds such as Axis Multi-Cap Fund that have weightage of large-cap to the extent of 92.61 per cent in its portfolio while in a fund like Invesco India Multi-Cap Fund large-cap stocks constitute only 37.44 per cent of the portfolio.
The problem is accentuated by the fact that multi-cap funds are one of the biggest sub-categories among equity-dedicated funds and were seen to corner almost one-fifth of the AUM of pure equity-dedicated funds at the end of August 2020.
As of August 2020, a total of 35 multi-cap funds had AUM of Rs1.46 lakh crore. If we go a little back into time and analyse the data, we see that the multi-cap category has remained one of the biggest categories in equity-dedicated funds. Although it has come down by a couple of percentages in the last 18 months, it has remained around 20 per cent. The graph below shows the movement of assets under management of multi-cap funds and their percentage in the equity category along with the number of funds in the category.
Probable Allocation Changes
Based on the above fact that 95 per cent of the multi-cap assets are invested in equity, out of which 70 per cent are in large-cap, 17 per cent in mid-cap and 8 per cent in small-cap, mutual funds need to lighten their position in large-cap stocks and increase their exposure to mid-cap and small-cap stocks. Assuming that fund houses decide to keep 50 per cent holding in large-cap (minimum allocation is 25 per cent), large-cap holdings could fall by Rs29,342 crore. At the same time, to hold 25 per cent in mid-cap stocks they need to buy Rs11,736 crore worth of mid-cap stocks. The biggest buying will come in smallcap stocks. To hold 25 per cent in small-cap, they need to buy of Rs24,940 crore worth of small-cap stocks.
Issue of Asset Allocation
The logic presented by SEBI in its circular is that in order to diversify the underlying investments of multi-cap funds across the large-cap, mid-cap and small-cap companies and be ‘true to label’, it has been decided to partially modify the scheme characteristics of multi-cap funds and they need to invest at least 25 per cent each in the above three categories. To understand the ‘true to label’ argument made by SEBI, we tried to find out the benchmark constituents of these multi-cap funds. Barring couple of funds, all the multi-cap funds are benchmarked against the BSE 500 or Nifty 500. The reason for selecting this benchmark is simple as they contain all the capitalisation stocks in them.
According to the regulator, the 1st to 100th company in terms of full market capitalisation are categorised as large-cap, from 101st to 250th the companies in terms of full market capitalisation are mid-cap stocks and finally the 251st company onwards, in terms of full market capitalisation, are small-cap stocks. Since BSE 500 and Nifty 500 contain the top 500 listed companies by market capitalisation they contain all these categories of companies in them.
Our analysis of BSE 500 index shows that the weightage of large-cap has remained above 70 per cent in the index since the start of year 2018 when SEBI through its circular dated October, 6 2017 defined large-cap, mid-cap and small-cap companies in order to ensure uniformity in respect of the investment universe for equity mutual fund schemes.
Hence, looking at the current asset allocation of the multi-cap funds, we see that they are very much aligned to their benchmark. Therefore, there is no doubt that the funds are very much true to the benchmark they have selected but this does not mean that they are ‘true to the label’.
Reasoning SEBI’s New Circular
As per the regulator, multi-cap as a category should be a fund that should have a good representation of all the capitalisations to call it truly multi-cap. Nevertheless, in the current juncture, small-cap stocks were lacking adequate representation in multi-cap funds and hence the regulator has had to intervene to make it ‘true to the label’. Our analysis also shows that the multi-cap fund category as a whole does not exhibit the character of a multi-cap but resembles more of large-cap and mid-cap indices.
To come to this conclusion we took the average monthly returns of all the multi-cap funds since the start of 2009. We then carried out a regression of these returns to monthly returns of Nifty, Nifty Large-Cap, Nifty Mid-Cap and Nifty 500 indices. We found that the returns of multi-cap funds are largely explained by the Nifty Large-Cap and Nifty Mid-Cap with higher statistical significance represented by the lower p-value i.e. less than 0.05. The following diagram shows the cumulative returns of multi-cap funds and different indices. This clearly shows how the returns of multi-cap funds closely follow the large-cap and mid-cap indices.
We went a step ahead and calculated the rolling beta (beta measures the fluctuation in a fund’s return compared to the overall market) of three-year returns between multi-cap fund and returns of the same indices. The result shows that throughout the period the beta of the fund was closer to one, which means that the fund returns were closely following the large-cap and mid-cap indices. The beta with other indices, namely, Nifty and Nifty 500, was very volatile in the same period and was negative as well in some periods. Therefore, we believe that naming the current funds under multi-cap fund will be a misnomer based on the current structure of the funds and their returns’ attribute. As such, we believe that the regulator is very much right in issuing its latest circular.
Do Large-Caps Mean Better Returns and Lower Risk?
One of the reasons why it has been argued that multi-cap funds biased towards large-caps are better for investors is because they exhibit better risk-adjusted returns. We tried to check how true this is. Contrary to this popular perception, we observed that there is a negative correlation between the percentage of large-cap holdings by the multi-cap funds and risk-adjusted return, as represented by the Sharpe ratio.
Relation between Sharpe Ratio of a Fund and Large Cap Holdings as Percentage of total Fund’s AUM
The diagram clearly shows that there is a negative co-relation between large-cap holdings in a multi-cap fund and its Sharpe ratio with good statistical significance. For example, Invesco India Multi-Cap Fund holds only 37 per cent of its corpus in large-cap stocks but has a positive Sharpe ratio. In the same period, a fund like Axis Multi-Cap Fund that holds more than 90 per cent of its AUM in large-cap has generated negative Sharpe ratio. Therefore, looking merely at the Sharpe ratio, we could not find any conclusive evidence that higher large-cap holdings result in better risk-adjusted return. To get a better understanding of the Sharpe ratio, we went one step ahead and tried to find out if there is any relationship between the AUM of a fund, Sharpe ratio and percentage of large-cap holdings.
Relation between Sharpe Ratio of a Fund and Large Cap Holdings as Percentage of total Fund’s AUM (Quartile wise)
We divided the multi-cap funds into four different quartiles depending upon their total AUM. The AUM of multi-cap funds ranged between Rs58.5 crore and Rs29,714 crore at the end of August 2020. So all the funds having AUM of less than Rs350 crore are grouped in the first quartile (Q1) and the funds with AUM greater thanRs10,000 crore are grouped in the fourth quartile (Q4). After this we ran a regression analysis and saw that every quartile except for the funds in the third quartile has a clear negative relationship with the percentage of large-cap holdings. Hence, a fund with large AUM and higher percentage of large-cap stocks holding in it does not mean that you will get better risk-adjusted returns. Now let us check how the multi-cap funds’ performance varies with small-cap holdings in their portfolio. Prima facie it seems that there is a positive correlation between small-cap holdings and the Sharpe ratio of the funds.
Relation between Sharpe Ratio of a Fund and Small Cap Holdings as Percentage of total Fund’s AUM
The diagram above shows that there is positive correlation between them. However, a closer look at the p-value (greater than 0.05) shows that we cannot rely on such a relationship. Therefore, the current data does not give any conclusion if the presence of small-cap holdings in multi-cap funds ensures better risk-adjusted returns. The above analysis clearly shows that though the presence of small-cap holdings does mean a better Sharpe ratio, what is evident is that large-cap holdings is definitely a drag on the overall risk-adjusted return. Therefore, looking at the current scenario, it seems that fund managers are conservative in their approach and want to be safe than sorry.
Moreover, it has been observed that most of the funds in a certain category tend to converge in the aspiration to look good in peer-group benchmarking. The freedom that is currently provided by the regulator is seldom used and therefore most of the multi-cap funds have turned out to essentially become large-cap funds. Further, investment in small-cap stocks may lead to higher impact cost for the funds. Besides, lack of detail and reliable information about the small-cap stocks may put the quality of financials and governance practices in doubt. A single bad investment may impact the entire fund’s returns. Therefore, a fund manager might be reluctant to increase the exposure to small-cap stocks.
What Should an Investor Do?
In this entire process, an investor in a multi-cap fund may find himself or herself confused about the right course of action. This is because a majority of investors might have invested in the funds looking at their asset allocation, which, as seen from the above details, has always tilted towards large-cap stocks. Now suddenly they are staring at a situation where they have to take exposure to small-cap stocks, which many a times are more volatile than the large-cap stocks. Most of the multi-cap funds have a reasonable representation of mid-cap stocks in the fund and hence any churning in that category is not going to impact much the character of the fund in terms of risk and returns.
Our suggestion would be to avoid displaying any knee-jerk reaction and it is better to wait and watch since the final changes will take place only three months later in the month of January 2021. Therefore, fresh allocation to this category should be avoided until and unless clarity emerges. In between, there are many possibilities which will make any of your current actions futile. For example, schemes can get reclassified as focused or large and mid-cap or enter into any other thematic category that a fund house proposes and the regulator accepts so that you can continue to hold.
Meanwhile, what we suggest is to go back and do your basic homework and check your current asset allocation. If your multi-cap fund holds more than 25 per cent or near about in small-cap funds then you do not have to do anything even if the regulation comes into effect from February 2021. Nevertheless, if your multi-cap fund holds less than 10 per cent in small-cap stocks and has AUM greater than Rs5,000 crore, you may see a visible change in the risk-return profile of your fund assuming it increases its small-cap stocks holding to 25 per cent.
In such a scenario, check how such an increase in small-cap holdings in the fund impacts your total asset allocation and the weightage of small-cap in your portfolio. If it breaches your tolerance level you should exit the fund. If it is within your comfort level you can remain invested in the fund provided it fulfils other criteria such as risk and return. Therefore, your action will depend upon the size of the fund you are holding, the overall asset allocation, and more importantly, how fund houses plan to make the transition. Till then, remain vigilant!