Decoding SEBI’s New Rules for Multicap Funds

Multicap Funds
- Open-ended funds that invest across market capitalizations. No restriction on the allocated proportion to each category.
SEBI Notification (11.09.2020)
- As per SEBI circular dated 11 September 2020, modifications have been made in the asset allocation requirements for multi-cap funds applicable from February 2021. Multicap funds will need to invest at least 25% of its assets in each of the categories, i.e., large-cap, midcap & smallcap.
SEBI Clarification
- SEBI on 13th September issued a clarification, saying mutual funds do not need to necessarily purchase 25% each in mid or small caps. Instead, they have the option to inter-alia facilitate switching to other schemes by unitholders, merge their multi cap scheme with other schemes or convert their multi cap scheme to another scheme category, for instance, large cum mid cap scheme.
Current Allocations
- There are a total of 35 funds in the multicap category (Annexure 4) with a total category AUM of almost Rs.1.47 lakh crores. The allocation to different categories is:
  - Large Cap - 1.1 Lakh Crore
  - Mid Cap - 24,128 Crore
  - Small-Cap - 8,648 Crore
  - The shortfalls in the Small Cap and Mid Cap categories are 28K crores and 12.5K crores respectively. (See table below)

Risks
- Lack of depth - The small cap universe does not have enough stocks or market depth to manage this kind of a huge investment in such a short time. This could lead to valuations getting stretched in the category.
- Restricted options - Since the good quality stocks are expected to get bought and valuations may be stretched, fund managers might need to start picking relatively weaker stocks for further allocation. Both of these above risks can lead to below-par returns.
- Liquidity risk - In case of an adverse market event, the relatively lower liquidity in the category can cause liquidation problems. The inability to exit stocks at the right price could be a major risk for some funds, especially the larger ones.
Action
- We hope AMFI will take the case up with SEBI, and the allocations in mid and small cap categories will be reduced to fairly represent the market weights.
- The option for mutual funds to change the fund category or merge with existing schemes, leaves a lot of choices.
- Depending on your tax status we suggest exiting some of the multi cap schemes (Annexure 1)
- Some of the schemes are being kept on the watchlist (Annexure 2). We recommend no further purchase in these currently. Investors may switch their SIPs to multicap funds on the buy list (Annexure 3) or individual category funds as per their risk-return profile.
- Fresh investments in multicap funds should be restricted only to the recommended buy list (Annexure 3).

Annexure 1 - List of Multicap Funds with Sell Recommendation

The large AUM of these funds means that the funds would need to re-allocate a substantially large value into the mid and small cap category.
This would need compulsory selling of current holdings - some of which could be winners.
Kotak Standard Multicap Fund would need to move approximately 2000 crores and 7000 crores to mid and small cap stocks respectively to meet the compliance. Total assets allocated to the small cap category as per current fund size would be close to Rs. 7,500 crores. This is larger than most small cap funds, and poses extreme liquidity and returns risk.
HDFC Equity Fund would need to reallocate close to 3,300 crores and 4,000 crores to small cap funds.
Axis Multicap Fund currently has no investments in small cap stocks and a very small portion in mid caps. This would mean liquidating current large-cap holdings.
All funds in the above list have fairly large AUMs which builds the risk of liquidation in mid and small caps.
Depending on the tax status of the units held, one may exit investments from the funds in the sell list.

Annexure 2 - List of Multicap Funds on Watchlist

The above funds have been kept on watchlist.
AUM sizes are not extremely large, which makes the small cap required allocation manageable. However, considering there may be disruption in small cap pricing and liquidity due to a spurt in demand, good quality stocks may not be available at fair prices.
ICICI Prudential Multicap Fund would still need to invest close to 1,000 crores in small cap stocks.
IDFC Multicap, L&T Equity Fund and Tata Multicap Fund are fairly comfortable as the required additional investments in mid and small cap stocks are as under:
- IDFC Multicap - Nil & Rs. 577 Crores
- L&T Equity Fund - Rs. 230 Crores & Rs. 370 Crores
- Tata Multicap - Rs. 45 Crores & Rs. 284 Crores
Recommended to restrict new investments. SIPs may be switched to either the buy list multi cap funds (annexure 3) or individual category funds.
Redemptions are not needed currently until further clarity is available.

Annexure 3 - List of Multicap Funds with Buy Recommendation

Nippon India Multi Cap Fund and Parag Parikh Long Term Equity Fund allocations to the mid cap and small cap categories are fairly close to the new SEBI mandate.
The required allocation from the large cap to mid and small cap stocks is not large and hence these funds are not expected to go through a major disruption.
We will continue to track the complete list of multicap funds, and further funds in the buy list will most likely come from the watchlist (Annexure 2), depending on various attributes.
Given the change in the regulation, we would also change certain ranking parameters in the multicap category during our next quarter rankings.

Annexure 4 - Complete List of Multicap Funds

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