SEBI's New Regulation on Multi-cap Funds and Market Behaviour-VRK100-11Sep2020
India's capital markets regulator SEBI on 11 September 2020 came out a new mutual fund regulation saying that it is mandatory for multi-cap funds (a category of equity funds under SEBI's categorization and classification of mutual funds introduced in October 2017) to invest 25% each of their assets in large-, mid-, and small-cap stocks. The following is my immediate response to this maverick regulation by SEBI.
While I do believe that SEBI should not constrain a fund manager's ability to move among various stocks and distort the markets by resorting to back-seat driving, I would like to point to the dramatic statements being made in the media.
There seems to be a notion that thousands and thousands of crores will move from large-cap stocks to mid- and small-cap stocks in the light of the changed SEBI regulations.
I do think this is a bit naïve. One must also consider the second- and third-order effects.
As per SEBI's rules on categorization, there are 10 types of equity mutual funds. Let us assume that the new rules will lead to a lot of churn as funds start selling large caps and move to small and mid-caps. This will affect all the other nine categories.
Why? Because small caps become mid caps, mid caps become large-caps, and large caps shrink into mid caps. At least in theory. As one category of equity mutual funds sees selling, another would witness buying. Due to this, overall selling and buying may be muted.
Moreover, the new categorization rules will come into effect only in February 2021.
The transition should be much smoother than is anticipated.
As per George Soros' reflexivity theory, "markets can influence the events that they anticipate." If sufficient market participants expect the Rs 40,000 crore bonanza, then money may move to small- and mid-cap stocks as is being theorised now. I do believe the chances are remote.
Let me explain with some examples.
HDFC Small Cap has 70% of its assets invested in small caps. Assume small-cap prices shoot up as is being speculated. The allocation of small caps in this fund may reach 75%. Due to liquidity concerns, the fund manager will bring down the small-cap stake.
ABSL Frontline Equity has 85% of its portfolio in large caps. Due to the anticipated shift from large cap stocks to lower market caps, the large-cap allocation may shrink to 75%. At which time, the fund manager may be forced to increase the stake in large caps to 80%.
My point is that the situation will be in constant flux, affecting all sorts of equity funds – large cap, mid cap, small cap, balanced, hybrid, thematic and sectoral.
Now let us further assume that more than Rs 40,000-crore or Rs 50,000 crore mutual fund assets would move from large caps in the next two months. This would put pressure on large-cap stocks leading to drop in the Sensex and Nifty. This drop may further lead to selling which could precipitate more selling. This feedback loop will lead to erosion of mid- and small-cap stock prices.
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Reference: For SEBI's circular new regulation on multi-cap funds: Tweet dated 11Sep2020
The above views expressed by me on my Twitter handle @vrk100 are carried by Morningstar India: weblink on 12Sep2020
Shout-out: I express my sincere gratitude to Ms Larissa Fernand (Twitter handle @larissafernand), Editor of Morningstar India, for help publishing my views on their website.
My Tweet thread dated 11 September 2020 >
As per this ET article, Rs 40,000 crore "bonanza" will move from large-caps to mid-caps and small-caps.
— RamaKrishna Vadlamudi, CFA (@vrk100) September 11, 2020
This seems to be naive thinking on the part of analysts, who seem to be missing the second-order, third-order and nth-order effects. 1/5 https://t.co/NFUaYQQcfu
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Multi-cap
funds: Additional comments I made on Twitter, during my interaction with others, between 11Sep2020 and 15Sep2020 (these additional comments were added in this blog post on 11Oct2020):
1)
Tweet thread
dated 14Sep2020:
The world is
divided between diversification and concentration. What is suitable for one
may not be suitable for others. Prudent management of funds means regulator
will have some investment restrictions--but they should not burden a manager's
flexibility.
SEBI's original circular and the
clarificatory one show that SEBI is clueless about market dynamics.
2)
Tweet thread
dated 14Sep2020:
Constant
tinkering with fund %ages will inject uncertainty into the minds of
investors--not many are sophisticated enough to follow the norms. Any
regulation needs to be nuanced, not blunt like this 25%.
Agree there are different
viewpoints and I respect those views. But the regulator should climb down its
high stupid ground. It's high time SEBI reduced the percentages for mid- and
small-cap stocks to like 12% or 10% in line with their weight in NSE 500 or BSE
500 index.
Unlisted firms are avoiding
listing due to SEBI over regulation, burden of excessive enforcement, higher
listing costs, and skewed policies. In India, investing opportunities are more
in unlisted space vs listed universe.
It's a well-known fact that due
to onerous capital controls and capricious and oppressive taxation; a large
part of Nifty and Rupee trading ( in NDF market) has shifted outside India.
Over-enthusiastic and wild regulation by regulators & gov't is killing
Indian businesses.
The kind of back-seat driving by
SEBI in fund management is so burdensome and oppressive that smart money
managers may consider shifting their base to say, Singapore, London or
Frankfurt.
3) Tweet thread dated
14Sep2020:
I'm sure all
mutual fund managers are seething with anger against SEBI's action that
severely constricts fund management and jeopardises investor interest. But so
far, no money manager has called SEBI's bluff openly. What are they afraid of?
Hypocrisy?
How could SEBI force an FM to
buy a certain %age of stocks when the stock universe is small? Is SEBI so vapid
that it's unaware of liquidity risk in mid-& small-cap stocks? Indian
markets lack depth, due to a variety of reasons, like, high compliance costs
& regulatory overreach.
I don't know
whether all the 700+ stocks in BSE SmallCap index will rise or fall in the next
few weeks reacting to regulatory action. But I'm sure select neglected stocks,
with low/manageable debt, high profitability, sustainable businesses and strong
balance sheets will do well.
5) More
tweets in the second week of Sep2020 on this hot
issue of new SEBI regulation on multi-cap funds:
The scenario
presented by you (small caps will rally after SEBI new regulation) is quite
possible. But the probability of this scenario is low in my opinion given the
precarious nature of the economy. This madcap circular may be used by market
players for satisfying their trading / selling instinct.
If market sell-off occurs, it
may be an opportunity for people who are on the sidelines with pots of money.
Long-term investors, in my
opinion, should not bother about this SEBI circular on multi-cap funds. There
is always a possibility that market will use this as an excuse and resort to
selling which is going to hurt mid- and small-cap stocks more than the
large-caps.
Exactly! HNIs with good
knowledge of international markets will tend to move away from Indian stocks
due to this capricious market regulators. It's not worth their time to remain
invested in Indian stocks.
Several fund houses are already
into all types of EMF categories. Only a few AMCs may be able to move from
multi-cap to other equity categories, provided the regulator permits the switch.
This is a good point! But some
AMCs are fully into all types of EMF categories. Only a few may be having this
option of switching, rules permitting. Another option would to merge multi-cap
funds into other types of funds with high large-cap exposure.
If only people (including me)
had spent more time on improving their skills rather than wasting time on this
madcap SEBI circular, productivity levels of India would surpass those in
advanced economies. And PM Modi's dream of USD 500-trillion-economy can be
achieved by 2023.
Snake
oil peddlers have already started selling their "wares" to the
greedy. (SEBI madcap circular).
Different scenarios are possible. My simple point is we should not base our investment strategy depending on the mood swings of the regulator. Long-term investors should pick stocks based on the fundamentals.
Another possibility is: AMCs may
persuade SEBI to change the tenor of this circular or dump it altogether.
Another option would be to change the large, small & mid cap definition. I
mean they may say top 150 are large caps (now top 100) and top 151-350 (now
101-250) are mid-caps.
SEBI rules permitting, merger
and / or re-classification of equity MF schemes will lead to changes in ranking
of individual MF plans in different EMF categories.
Indian financial regulators, be
it SEBI or RBI, etc., confuse regulation with action. SEBI failed miserably to
check MF mis-selling, debt funds misusing their mandate, promoters' greed and
fraud, and several others. To offset their incompetence, they come up with
mindless norms.
Fund managers need full control
over plan assets. SEBI's rules on categorization and reclassification are
useless. They norms don't benefit investors at all.
Sir, as you know, there are
several moving parts. AMCs rejigging their portfolios, traders and investors
churning their portfolios, and SEBI coming up some more new norms. Long-term
investors should not worry too much (about this regulation).
As you know, nothing works in
isolation in markets. All kinds of scenarios are possible. But we need to think
in terms of probability (odds) of these possibilities. I don't know how the
market reacts, hence I should follow a strategy that is suitable for me.
Hefty money
managers say they will 'wait and watch.'. It's quite possible they would do the
opposite. Markets are cold-blooded. They don't give two hoots to platitudes.
Going by the commentary, it seems a big jolt is
coming in the next 3 to 4 days. But, this optimism needs to be tempered with
SEBI future action--I suspect that SEBI should definitely bring down this 25%
madcap limits to say 12% or 8%. Otherwise, active fund mgmt is pointless.
In any other
country, the incompetent heads would have been 'sacrificed.'
This two-day storm-in-a-tea-cup
cost us Rs 50,000 crore national income. Total waste of time!
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Disclosure: I've vested interested in Indian stocks. It's safe to assume I've interest in the stocks discussed, if any.
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