Multi Cap Funds – A Jig or A Rejig

The Definition

Multicap Funds (until Jan ’21): An actively managed equity fund, where the fund manager has the discretion to actively allocate assets across categories – large cap, mid cap, small cap.

Multicap Funds (wef Feb ’21): An actively managed equity fund, where the fund manager has the discretion to actively allocate 25% assets across categories – large-cap, mid-cap, small-cap, cash.

The Modification

SEBI vide its circular no. SEBI/HO/IMD/DF3/CIR/P/2020/172 dated 11th September 2020 announced the changes to the asset allocation requirements for multi-cap funds. Multi cap funds will now need to allocate a minimum of 25% of its assets (AUM) in each of the categories – large, mid, and small. This compliance needs to be met within 1 month from the date of publishing of the next list of stocks by AMFI, i.e., January 2021.

In this note, we briefly try to understand the impact of this move on not only multi-cap funds, but also its impact on other categories. This article attempts to link that to how investors are expected to or should react to this move.

The Numbers as they Stand

The total Assets Under Management for the multi cap category as of 31st August 2020 stands at Rs. 1.46 crores plus. There is a total of 35 funds in the category with approximately Rs. 1.1 lakh crores allocated to the large cap universe. This works out to a whopping 75% of the total assets in the category. Add to this the nearly 2% the AMCs keep as cash to meet redemptions and expenses and it leaves 23% cumulatively allocated to the bottom 2 categories.

The table above shows the allocation across categories, both in terms of proportion and value in the different categories by the top 10 funds (in terms of AUM size).

The Rationale

At first instance, like most experts have already pointed out, this looked like an unnecessary micro-management move from SEBI.

But what could have prompted this? – Let’s take a look.

As we already pointed out, only 23% of the total assets under management are allocated to the mid and small categories. In fact, only 5.90% is invested in small caps. If we take a deeper dive into individual funds, we can see some astounding figures (see – red circles in table below). A couple of the large fund houses (namely, Kotak and Axis) have invested only 1.19% and 0% of their assets in small caps. Yes! – 0%. One does not need a 180 IQ to figure that in no way is investment across categories (‘multicap’).

The skewness of allocation to the large cap space is way too high. Motilal Oswal and Axis Mutual Fund have 89% and 92% allocated to the top category (green circles in the table above). This beats the allocation to the category by a number of large cap funds, such as of Kotak Bluechip Fund which has 81% (of course that’s Kotak’s choice. The idea is to highlight the disparity).

This is surely what caught the eye of the regulator (at least I hope so), and hence the need to micro-manage.

Good Move?

Given the data above, one cannot deny the allocations were not truly fair to the category name. If the funds are not going to invest any assets to a category, then the investor could have rather put his money in a large cap fund. At least that way he would know the money is where the mouth is. So probably it was time for the regulator to step in and take the AMCs back to the drawing board and explain the meaning of multi.

What is surprising though is the number behind the allocation – 25%-25%-25%. How the #@$# do you arrive at that allocation as the minimum required?

The risk-return characteristics of each of the categories is totally different from the other. The volatility in the small cap space is nothing less than riding a goat at 80 km/hr on the Mumbai roads. Even if I wanted to diversify, why would I want a quarter of my portfolio to go through that? That would really be a pain in the ____ and could lead to irreversible injuries?

What Then?

The idea of suggesting a multicap portfolio to a client would be to get a fair diversification from a single fund. What is a fair diversification you may ask? Well, something that closely replicates the market capitalization wouldn’t be too bad.

India’s total market capitalization as of 11th September 2020 is just shy of 160 lakh crore rupees. Of this close to 70% is in the top 100 companies, while the next 150 companies and the balance of the universe share the remaining almost equally.

From this, if we are to take out a portion for the fund managers to actively manage and assuming the regulators (and other higher authorities) want to do more for the small and medium segment, something like a 45-20-10 or 40-20-15 is something I’m sure the fund houses, advisors and other experts would have been much more comfortable with. This would have served the purpose of making the fund diversified across multiple categories and yet not been a big burden. Why do I call it a burden? Let’s look at that next.

The Burden

So, what is the problem if fund managers now need to allocate 25% to small or midcaps? Why is everyone making such a hue and cry about that?

If we go by the current invested AUM in the category, the large cap category has an excess of Rs. 36.5K crores over the permissible new allocation regime. This (and a lot more to provide for cash) would need to move out of large caps and move into midcaps and small caps. The minimum investment required in these categories is 12.5K crores and 28K crores to meet the criteria.

Even though the small cap basket in theory has over 1000 active stocks to choose from, sadly, most of these stocks are un-investible due to various reasons (we’ll leave the discussion regarding these reasons for another day).

So, for ease of discussion, let’s assume the BSE Small Cap Index as the benchmark. The total market cap of the category is 23 lakh crores. However, of this, the total free float (shares available for trading) is only 8.83 lakh crores. To top that, a large percentage of this is either held privately or held by institutions and HNIs for long-terms and is illiquid in nature. Small cap mutual funds in India already hold 52,000 crores assets and multi cap funds have over Rs. 8K crores. Now, multi cap funds would need to dedicate another 30,000 crores.

The question to ask is – are the small cap stocks worthy of so much money. Well, some of them (maybe a few 10’s or maybe 100) might be worth a lot of money. But then would it not be a case of too much money chasing too few goods (stocks in this case) – and hence inflation (economics holds true everywhere). Valuations are going to get pushed up without the earnings and that is exactly what creates bubbles.

Investor Angle

This has so far been a problem of the industry, the AMC and the fund manager. But as an investor does it really matter to my life? In fact, isn’t it a good thing that the prices will go up for stocks and hence I will get better returns?

Wish it were that simple. Initially it may play out exactly that way. However, numbers reveal a lot more. Some of the small cap funds already carry very high inventory.

Nippon Small Cap Fund – Rs. 9,285 crores
HDFC Small Cap Fund - Rs. 8,645 crores
SBI Small Cap Fund – Rs. 5,039 crores

Numerous top advisors and experts have been advocating against investing in these funds, as the average ticket size of the underlying holdings becomes too big. In case of a catastrophic event, illiquidity could kick in and getting out of positions could be a nightmare for the fund manager. This in turn could be the end of some hard-earned capital for the investor.

Going back to the multi cap funds now, let’s take the case of a Kotak Standard Multicap fund. With assets close to Rs. 30,000 crores, the fund would now need to deploy at least Rs. 7,500 crores (remember the new 25-25-25 rule by SEBI?) in small caps. This is as good as running a large size small cap fund, which would be advocated as a no-go by most experts. So, this is the first reason why an investor might look to get out of a multi-cap (at least the larger ones).

Reason number 2 for an investor to consider an exit from multi cap funds – somewhere along this article I mentioned the volatility that comes free with small caps. 25% of the portfolio is small caps is surely not a fair diversification for a normal investor. There may be some high-risk takers and daredevils out there, but one-size does not fit all. So, the investor may want to look at exiting a multi cap and prefer taking positions in the individual categories as per one’s risk profile.

Action

So, come Monday, should investors start booking out of multi-caps and invest in large caps? That would be logically contradictory as multi caps now need to sell large cap stocks to meet the statutory requirement of 25%. But please do not go out selling all your large cap funds and stocks. We believe the market has enough depth and liquidity to take Rs. 40,000 crore worth of selling over a period of 5 months.

Then do they redeem their multi cap fund and jump head-first into mid or small cap funds? Aren’t you adding to the bubble which may burst any time? Unless you’re a punter, this is certainly not advisable. The time frame available is 5 months. Who knows when this rise will come in the period - if at all.

Then what? Well we hope better sense prevails and SEBI reconsiders its stand on this 25-25-25 rule. If the allocation must be enforced, a more just allocation would have better acceptance from everyone – the industry, the investors, and basic economics. A readjustment to a 45-20-10 allocation would do the job much better.

Investors need to start relooking at their portfolio without losing the long-term objectives. It may be prudent to start investing in individual category funds as per one’s own risk-return profile and goals. Our team is currently working on the action required in terms of specific funds that may be advisable and very soon we would have the link to that here.

For the AMCs, we are sure they are already looking at the options of recategorization of the category if SEBI does not change its stance. It is logistically very difficult and economically very expensive to keep the proposed asset allocation.

In the end, like all the other things that happen on this revolving ball, what happens with this one, only time will tell.