Should SEBI revisit MF Categorization: To widen Large & Mid Cap categories?

Remember SEBI’s Mutual Fund Categorization exercise of 2018?

The primary purpose of that monumental exercise was to bring uniformity between schemes offered by different Mutual Fund Houses and to reduce investor’s confusion, thereby helping investors to easily understand schemes and pick the right funds to properly link investment to financial goals. I had written about it in detail then and also highlighted why it was part of the 3 big changes in mutual funds space then.

Now in 2020, it seems that SEBI is considering revisiting the definition of large-cap, mid-cap and small-cap stocks for mutual funds categories. As of now, the definitions stand as follows:

• Large Cap Stocks: First 100 companies by full market cap
• Mid Cap Stocks: 101^st to 250^th company by full market cap
• Small Cap Stocks: 251^st company onwards by full market cap

In addition, the classification had clearly defined schemes along with their allocation rules: Like the 10 categories in Equity Funds, 16 Debt Funds categories and a few more in hybrid and solution-oriented funds.

So what are the expected changes to these definitions?

I am not sure as I am not an insider. Also, let’s cross the bridge when it comes. But to hazard a guess and from what I hear from various sources, the new definitions might be as following:

• Large Cap Stocks – 1^st to 150^th company
• Mid Cap Stocks – 151^st to 300^th company
• Small Cap Stocks – 301^st company onwards

There is also a remote possibility of making this a dynamic segregation. But seems to be less probable.

There can be multiple reasons for going with these revised definitions but it seems that fund managers had growing concerns about too much money chasing few stocks in large and mid cap space. And hence, they reached out to SEBI to expand the universe of stocks that are currently part of large and mid cap space. Seemingly, changing definitions will provide equity fund managers more flexibility and increase the scope for making investments for their fund portfolios.

Is this required?

I am not an expert and I know only a few things. But this is what I think about this case:

• The original MF categorization & rationalization exercise of 2018 was a much-needed cleanup of the mutual fund universe. And since it was an event with large scale implications, it is only fair to acknowledge that it’s not always possible to get big projects right in the very first time. Things do improve incrementally. The exercise brought sanity to the fund space by controlling the definition of what was large cap and what was mid cap and what was small cap. As time progresses, it’s possible that these definitions may require minor tweaking every now and then. So maybe, if and when SEBI decides to tweak these definitions, it will be well-thought-out and may be necessary as well.
• I also feel that earlier rules for scheme-level constitution provided sufficient flexibility to fund managers. I am sure not all fund managers are alike and their views would differ. But I think sufficient (and not too much) flexibility was provided. For example – as per the current rules, large-cap funds would have to invest at least 80% in large-cap stocks, i.e. in the top 100 stocks. So this left about 20% flexibility for fund managers to invest across large, mid or small caps. And being a large-cap fund, I think having a major chunk in the large caps (~80%) is the right thing to do. Similarly for mid-cap funds, they had to invest a minimum 65% of total assets in mid-cap stocks (and small-cap funds had to invest 65% in small-cap stocks). These again provide sufficient flexibility of the remaining 35% to invest elsewhere in search of alpha or for capital protection or timing the market or whatever was the fund manager’s agenda.
• Also, many felt that since the list of stocks in large, mid and small cap space was updated once every 6 months, it might result is forced selling (or buying) of some shares when they exited one cap category and entered other. I think here also, sufficient freedom of 20% in large cap funds and 35% in mid cap funds and small cap funds was provided to negate the need for forced exit due to category change of the constituent stocks.
• Some feel that expanding the definition of categories for large-cap stocks will help in generating outperformance in the long run. It’s possible no doubt. But it’s not necessary if you think about it. It’s even possible that it will introduce the opposite increased downside risk since comparatively smaller companies will be incorporated in the new large-cap definitions.

I again say this that SEBI has investor’s best interest at heart and hence, will be taking the right decision at the right time.

Since the previous categorization exercise was a major one in itself, its possible that minor tweaks every now and then will make Mutual Fund Categorization work even better than it already was working.

I think that over the last 2 years, investors have begun to understand fund categorization better. And those who understand that different goals require different funds have benefited from the categorization exercise immensely.

So whether there are any changes to the definition or not in near future, it’s best for common investors to continue focusing on Goal based Financial Planning, sticking to fund categories that are suitable for their financial goals and continue tracking investment performance and make course corrections where necessary.