ARTICLE
3 January 2025

Expanding the Investible Universe of Large Cap and Mid Cap Schemes of Mutual Funds – A Conundrum

SA
Shardul Amarchand Mangaldas & Co

Contributor

Shardul Amarchand Mangaldas & Co founded on a century of legal achievements, is one of India’s leading full-service law firms. The Firm’s mission is to enable business by providing solutions as trusted advisers through excellence, responsiveness, innovation and collaboration. SAM & Co is known globally for its exceptional practices in mergers & acquisitions, private equity, competition law, insolvency & bankruptcy, dispute resolution, capital markets, banking & finance and projects & infrastructure.
Amid a broader market downturn in recent months, small cap stocks have shown surprising strength. This performance runs contrary to usual expectations of sharper drawdowns in small cap stocks...
India Finance and Banking

Amid a broader market downturn in recent months, small cap stocks have shown surprising strength. This performance runs contrary to usual expectations of sharper drawdowns in small cap stocks when market conditions turn sour. As a result, off-late, small cap mutual funds have topped the mutual fund performance, riding the frenzy in the space. Investors continue to pour money in these funds (including SME IPOs), but risks are also more pronounced now. While potentially very rewarding, small cap space is known for sharp drawdowns and protracted recoveries. The fear is that investors could get their fingers burnt.

A mutual fund ("MF") is a collective investment vehicle that collects andpools moneyfrom investors at largeand invests the same in underlying securities i.e.equities, bonds, government securities and money market instruments, in accordance with the objectives of the scheme as disclosed in the fund offer document. Investors are issued units by the MF. Unit is the interest of the unit holders in a scheme, whereby each unit represents one undivided share in the assets of the scheme.The incomegenerated from a MFscheme isdistributed proportionately amongst the investors, after deducting applicable expenses and levies, by calculating a scheme's "Net Asset Value/NAV" [(Total Assets – Total Liabilities)/Total Units)].

MFs in India are established in the form of a Trust under Indian Trust Act, 1882 and regulated by Securities and Exchange Board of India ("SEBI") in accordance with SEBI (Mutual Funds) Regulations, 1996 ("MF Regulations").

Schemes of a MF are broadly classified as follows:

  1. Equity;
  2. Debt;
  3. Hybrid;
  4. Solution Oriented;
  5. Others (Index Funds, ETFs and Fund of Funds [overseas/domestic]).

For this write-up, the discussion is restricted to large cap, mid cap and small cap equity MF schemes.

While the MFs in India are registered and regulated by SEBI pursuant to MF Regulations of 1996, MF Regulations hadnever defined the categories of equity schemes such as - MultiCap Fund, Large Cap Fund, Mid Cap Fund, Small Cap fund, Value fund, Contra fund etc. There was no uniformity or standardisation across MFs as regards characteristics and type of schemes depending on which they would fall in a particular category such as: large cap or mid cap or small cap.

In view of the above, SEBI felt it desirable that different schemes launched by MF should be clearly distinct in terms of asset allocation, investment objective, benchmark and investment strategy. This move was to ensure that an investor of MFs can evaluate the different options available, before taking an informed decision to invest in a scheme.

Accordingly, in October 2017, SEBI categorised the MF [open ended] schemes ("SEBI Circular") as follows:

  1. a large cap fund is required to invests at least 80% in large cap stocks;
  2. a mid cap fund is required to invest at least 65% in mid cap stocks; and
  3. a small cap fund is required to invest at least 65% in small cap stocks.

To ensure uniformity in respect of the investment universe for equity schemes, large cap, mid cap and small cap stock was defined as follows:

  1. Large cap stock is defined as: 1st – 100th company in terms of full market capitalisation;
  2. Mid cap stock is defined as: 101st – 250th company in terms of full market capitalisation; and
  3. Small cap stock is defined as: 251st company onwards in terms of full market capitalisation.

Some of the other requirements prescribed by the SEBI Circular are as follows:

1. MFs would be required to adopt the list of stocks prepared by AMFI1 and AMFI would adhere to the following while preparing the list:

  1. if a stock is listed on more than one recognized stock exchange, an average of full market capitalization of the stock on all such stock exchanges, should be computed;
  2. in case a stock is listed on only one of the recognized stock exchanges, the full market capitalization of that stock on such an exchange should be considered; and
  3. this list would be updated every six months based on the data as on the end of June and December of each year based on the previous six-month performance of stocks.

2. After updation of the list by AMFI, MFs are obliged to rebalance their portfolios (if required) in line with updated list, within a period of one month.

3. MFs must strictly adhere to the scheme characteristics as well as the spirit.

4. MFs must ensure that the schemes so devised do not result in duplication / minor modifications of other schemes offered by them.

5. MFs are permitted to launch only one scheme per category barring few exceptions such as Index funds, ETFs, fund of funds, sectoral & thematic funds.

Because of the SEBI Circular, asset management companies were also required to align the then existing MF schemes by either winding up / merging the schemes or change the fundamental attributes of the schemes in accordance with the MF Regulations. The list prepared/updated by AMFI thus, serves as a reference for active domestic fund managers of Indian MFs to rebalance their scheme investments.

Accordingly, AMFI, in consultation with SEBI and stock exchanges, prepares the list of stocks, based on the data provided by stock exchanges. In terms of the list issued by AMFI, following was the average of the full market capitalisation of the stocks listed on all stock exchanges during the six months ended 31 December 2017:

Average market capitalisation of all exchanges

(~INR in Crore)

Large cap (1st stock)

5,48,702

Large cap (100th stock)

29,304

Mid cap (101st stock)

29,255

Mid cap (250th stock)

8,584

Small cap (251st stock)*

8,580

Small cap (500th stock)*

2,797



* Only first 250 small cap stocks have been considered.

Following is the average of the full market capitalisation of the stocks listed on all stock exchanges during the six months ended 30 June 2024:

Average market capitalisation of all exchanges

(~INR in Crore)

Large cap (1st stock)

19,47,848

Large cap (100th stock)

84,325

Mid cap (101st stock)

82,452

Mid cap (250th stock)

27,564

Small cap (251st stock)*

27,480

Small cap (500th stock)*

9,188



* Only first 250 small cap stocks have been considered.

Sharp surge in market capitalisation threshold (anywhere between three to four times from December 2017 to June 2024) makes one ponder, whether SEBI should consider changing the stock classification methodology, or increase the number of large cap stocks (from present first 100 stocks to say first 125 or 150 stocks) and consequently increase the number of mid cap stocks (from present 101 to 250 stock to say from 126th/151st company to 275th/300th company or more).

Arguments in favour of expanding the investible universe of large cap and mid cap stocks:

  1. Sharp increase in the market capitalisation of mid cap and small cap companies over the past few years (as can be seen from the tables above), has greatly improved their liquidity, along with the rising SIP inflows.
  2. Large scale retail participation on the newfound economic prospects of the country and rush of companies to list on exchange by launching initial public offerings ("IPOs).
  3. Rise in number of demat accounts.
  4. Will help investors reduce concentration risk.
  5. Reducing the mandatory investment requirement in small and mid cap funds could provide fund managers with more flexibility to manage risk. This would allow them to invest a larger portion of the corpus in large cap stocks, if they deem fit necessary.
  6. Restricts the ability of the fund manager to generate alpha i.e. additional return above the scheme benchmark, because of restricted investible universe.
  7. Sharp increase in share of mid and small cap in the overall market indicates the rising risk, especially for retail investors.
  8. Stretched valuations can lead to a situation where stock prices become disconnected from the underlying fundamentals of the companies, increasing the risk of a correction, hence expanding the universe may hedge the risk to some extent.
  9. Will allow fund managers greater legroom to outperform the benchmark.
  10. The present universe hinders effective risk management by fund manager managing the schemes.

Arguments against expanding the investible universe of large cap and mid cap stocks:

  1. There is enough flexibility to invest in stocks outside their respective universes.
  2. Large cap funds can allocate up to 20% of their corpus to small cap and/or midcap stocks, while midcap schemes have even greater flexibility, with a limit of 35%.
  3. Small and mid cap stocks are generally less liquid compared to their large cap peers.
  4. Despite the sharp increase in IPO, valuations of mid and small cap stocks continue to be in an unattractive zone relative to large cap stocks, although their growth expectations continue to attract retail investors.
  5. The rise in market capitalization is purely attributable to rising liquidity i.e. shift in savings by retail investors to financial savings and this liquidity party may not last for long and is temporary.
  6. Apart from selling by foreign portfolio investors, even promoters are selling their stakes through offer for sale ("OFS") or block deals, suggesting that valuations may have peaked out. However, the flows are so strong that in certain cases the current market price is even higher than price at which OFS or block deals have taken place.
  7. Some MFs have placed restrictions on lumpsum investments in small cap funds, citing valuation concerns and lack of fresh investment opportunities in this area. MFs adopting a conservative approach in deploying funds in IPOs (including in the anchor book) are selective because of frothy valuations.
  8. Increase in cash holdings as a percentage of assets by MFs suggests that, MFs are adopting a cautious approach and may prefer holding cash in anticipation of potential market correction or they believe that the market is expensive.
  9. There is little or no margin of safety in mid and small cap investing.
  10. During periods of market optimism and strong performance, substantial capital becomes readily available for speculative activities also. Such an environment often drives a surge in IPO activity, fuelled by heightened investor activity and an increased appetite for risk. Historically, such fund-raising booms have signalled the late stages of market cycles. When capital flows abundantly, investors often overlook company fundamentals, leading to eventual market corrections as the exuberance fades.
  11. Small cap stocks tend to have higher beta [stock is more volatile than the market] than large caps, and they are therefore expected to outperform in a generally rising market.
  12. Historically, when small caps fall, they can fall very sharply. When the froth reduces (as is the case also with any frothy liquid such as foam that forms above the phase of a coffee) in small cap stocks, it is believed that prices will become more reasonable and with time, this adjustment will hopefully occur.
  13. Often markets swing between exuberance and extreme pessimism, however either phase do not last forever as things tend to revert to mean.
  14. Heightened regulatory concern on the surging inflows into small and mid cap funds and any potential ripple effects on the financial system if investors suddenly started to redeem their money from them.

The significant inflows seen in the mid and small cap funds have no doubt raised concerns about their stability during a sharp market decline or downturn. Following COVID-19, mid and small cap indices have outpaced large cap indices. The relentless ongoing market rally has resulted in triple digit returns for many small and mid cap stocks, attracting a growing number of investors, many driven by fear of missing out (FOMO). This trend is also reflected in the surge of new investor demat accounts and the unprecedented number of new investors in small cap funds.

Small cap stocks have been the market's focal point for the past few years, delivering exceptional returns, while large caps have largely been neglected by investors. In fact, for the first time in history, the number of small cap fund investors has surpassed that of large cap fund investors. However, most of these new small cap investors have never experienced a bear market. The critical question thus remains, how many will survive the next bear market?

Data suggest that India's market capitalization has grown faster than its GDP in past few years despite the Covid pandemic and the market capitalization to GDP ratio (known as Buffet Indicator) is overvalued.

It is said that, over long periods of time, stock prices are slaves to earnings. Hence stock prices which are dependent on flows (liquidity) is a scary situation. For any investor, buying good companies at reasonable prices always adds to the probability of making a reasonable return over the long term.

Historically, small cap stocks are considered illiquid and get hurt the most in every cycle. SEBI believes that froth is building into the small funds and wants to ensure that small cap funds can handle unexpected redemptions. SEBI wants to ensure that fund houses have enough liquidity and a plan in place to sell the stocks. MFs were therefore required to carry out stress test of their schemes and declare the outcome of the same for the benefit of unit holders. Stress test determines how quickly a fund manager can sell small and mid cap stocks, if many investors put in requests to redeem their units. It also tests what would be the price impact i.e. whether selling these stocks would bring down their price significantly or not. In other words, stress test provides insights into the liquidity profile of the MF's portfolio. It indicates the fund's ability to convert assets into cash within specific time frames under stress conditions. For investors, this information is crucial for understanding the fund's liquidity risk.

Conclusion:

Raising of funds via a new fund offer by a MF scheme is akin to an IPO by a company seeking listing (SME or main board) on stock exchanges. Hence, as is the case with any fund raising from public, SEBI is constantly on its toes to ensure that, investors in securities markets are protected. So far SEBI has done well to protect investors. Only time will show, if SEBI considers it appropriate, to expand the existing universe of large and mid cap stocks or amend the stock classification methodology, after considering various aspects, including some of them discussed above.

In the meanwhile, and notwithstanding the above, what investors need to be mindful of, while investing (in small cap or mid cap schemes/stocks), is what Warren Buffet in the 2008 letter wrote to the shareholders: "price is what you pay, value is what you get", meaning that there is a clear distinction between the price and value whether we are talking about valuation of a business, stock markets and product ownership [or services]. The price is the amount of money you spend on purchasing the underlying, while value is the quality and the benefits you receive from owning the underlying.

Footnote

1. Association of Mutual Funds in India (AMFI) is a non-profit industry body of the asset management companies of all Mutual Funds in India that are registered with Securities and Exchange Board of India. AMFI is dedicated to developing the Indian Mutual Fund industry on professional, healthy and ethical lines, and to enhance and maintain standards in all areas in the best interest of investors and other stake holders.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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