Multi-Cap Fund Allocation Rule Change (2020) + Impact on your MF Portfolio

SEBI has modified the rules for Multicap equity mutual funds. So now a detailed allocation structure has been introduced for multi-cap funds. This has been done via a circular on ‘Asset Allocation of Multi-cap funds’ (dated 11-Sep 2020: link or download here).

Going forward, all the schemes within this category will have to adhere to the new structural requirements. And what are those requirements?

Each Multi cap fund will be required to invest a minimum of 75% in equities and equity-related instruments (till now, the older rule was to invest a minimum of 65%).

This minimum 75% equity investment has to be done as follows:

• Minimum 25% allocation to Large-cap companies
• Minimum 25% allocation to Mid-cap companies
• Minimum 25% allocation to Small-cap companies

(Large Cap companies are identified as the Top 100 stocks on the basis of market capitalisation. Mid caps as stocks from 101st to 250th and Small caps are stock 251st onwards. To know more about this, read Large Vs Mid Vs Small Cap companies).

The AMCs have been provided time till 31st January 2021 to comply with the latest rules, i.e. within 1 month of AMFI’s next list of large, mid and small-cap stocks (regularly updated at this link).

Before this rule change and as per the original MF recategorization & rationalization (2018) exercise, there were no market-cap linked requirements or any prescribed percentage allocations (for large / mid / small cap stocks) for multi-cap fund managers to follow. They had the flexibility to invest across market capitalisation as per their choice and strategies.

Though sometime back, there was a discussion about SEBI planning to redefine Large & Mid Cap to include more companies (read more at Should SEBI revisit MF Categorization to widen Large & Mid Cap categories)? But that proposal didn’t go through.

But all said and then, what was the need for this change in allocation rules and for a lack of better word, sudden disruption in MF space?

To be honest, only the regulator knows best about this.

But there have been some clarifications offered (later) about the reason. Primary being SEBI’s concern that many Multi-Cap Funds were running a large-cap portfolio disguised as multi-cap. And they at times had almost negligible exposure to small-cap stocks. So in order to ensure that these funds were more ‘true to label’, SEBI decided to enforce a minimum 25% holding each of large, mid and small-cap stocks.

After the announcement, there was sudden panic in the MF space. This led to many investors asking whether they should exit from multi-cap funds. So to soothe the nerves of nervous investors and fund managers, SEBI had to come out with some justifications (via a new circular dated 13-Sep-2020: link or download here).

It said that one of the reasons for this was (as I mentioned earlier too) “to diversify the underlying investments of Multi-Cap Funds across the large, mid and small-cap companies and be true to label.”

In the same circular, SEBI also outlined various options available to fund managers to comply with new rules. So“apart from rebalancing their portfolio in multi-cap schemes, they could inter-alia:

• Facilitate a switch to other schemes by unitholders,
• Merge multi-cap scheme with large-cap scheme or
• Convert multi-cap scheme to another scheme category, for instance, large cum mid-cap scheme.”

Since the additional clarifications didn’t actually have the intended effect (and because the suddenness of new rule change was yet to sink in), SEBI has said that it is open to examining the (alternate) proposals from the MF industry and that MF fund managers and investors shouldn’t panic or make any hasty decisions.

Since it’s possible that there might be some changes in future (as SEBI has said it is open to suggestions), it’s not right for me or anyone to judge anything. In any case, I don’t consider myself as an expert. But nevertheless, here are few points to ponder over about this whole change:

• No doubt, the new rules will take away some of the flexibility of the fund manager. So the go-anywhere approach of multi-cap funds will now be severely restricted. Since a minimum of 25% each in small, mid and large-cap is mandated, the only flexible part of the portfolio (allocation-wise) is the remaining 25%.
• This will also limit the fund manager’s ability to capitalize on opportunities across market caps – which would have been comparatively easier earlier due to the go-anywhere nature of these funds.
• There is a possibility that since the riskier small-cap stocks will form at least 25% of the fund portfolio, the return profile of the category will be open to more volatility in future.
• And you never know if this rigid rule of having equal exposure to each segment may result in making the average return profile of multi-cap funds a little less attractive at times, if not always.
• But I agree with SEBI’s view too that many fund managers ran their multi-cap funds as pseudo large cap funds. This rule change will address this aspect to a large extent. Of course there will be many ramifications of this too. But that’s a tradeoff to be accepted now if this rule stays here in its original form.
• If small-cap stocks were not suitable for a particular investor due to his risk appetite (assuming he was a bit conservative), the multi cap fund’s 25% exposure to small-cap stocks will be an unnecessary risk into his overall portfolio. On the other hand, investors who had higher risk appetite and wanted exposure to mid- and small-caps without directly getting into them, will fund this rule useful from their perspective. So this suitability aspect of multi-cap funds will now have to be handled on a case-to-case basis.
• I may be wrong in this but given the size of the AUM under multi-cap category, it might be difficult for small cap stocks to absorb the 25% of this category’s portfolio. More so if this reshuffle of fund portfolio happens in a very short frame of time. But maybe, there are second-order effect of this change which we are not able to comprehend as of now. This will be an interesting space to watch though.
• Some existing funds (with big AUMs) will find it really tough to rebalance their portfolios without impacting the prices of small cap stocks they are planning to invest in. On the other hand, smaller funds will find it easier to rebalance. But at least SEBI has clarified that rebalancing is just one of the many options (and not the only one), other being mergers and converting funds to different categories.
• And because of the above reason, some funds will switch categories no doubt. And many will merge with other funds of different categories.
• It’s possible that SEBI might announce a new category – something like ‘Flexi Cap’ which more or less retains the flexibility which the original multi-cap rules offered. I am just guessing this. Don’t rely on this happening.
• I may be wrong but maybe instead of 25%, having a lower threshold (like 10-15% each) would have been less disruptive for the category as a whole.
• Since the minimum exposure is rigid (at 25% each), if one part of the market cap faces extended poor run, it will also depress the returns of the multi-cap funds to that extent. Since fund managers will not have the flexibility to move out of such market cap stocks, investors need to reset their expectations from these funds then.

These are just some of the initial thoughts I have about the development.

By the way, if you have some confusion (as many people mailed me) about the differences between Multi-Cap Funds, Vs. Multi-Asset Funds Vs. Dynamic Asset Allocation Funds, then here is a short comparison.

• Multi-Cap Funds – These will now have 75% equity exposure, plus with the new additional mandate of having at least 25% in each large, mid and small-cap stocks.
• Multi-Asset Funds – These are required to have a minimum 10% each in each of the 3 assets: equity, debt and gold.
• Dynamic Asset Allocation Funds – These come under hybrid category but have the option of actively managing their equity and debt allocation depending on their strategy or market conditions. Unlike multi-cap funds (now), the dynamic asset allocation funds have the flexibility to invest across market caps in any % which they deem fit.

From what I know, the MF industry is planning to approach SEBI for revisiting the rules, therefore this is a developing story. The impact may be different if the rules are tweaked or postponed or something else. You never know.

So don’t act in a hurry.

Wait.

Let some clarity emerge first.

As I said, even the AMCs / fund houses are still evaluating what to do. And even approaching SEBI to listen to them (and possibly) change the rules a bit to help their case.

So don’t be in a hurry to do something knee-jerk. Relax.

And if you really have to act, then talk to your investment advisor first to guide you. Else, if you are a DIY guy and invest on your own, then be careful about what you do.

If the rule stays, investors would have to reassess their multi-cap exposures and more importantly, the underlying exposure to mid and small-cap stocks. A portfolio review would be required to ensure that their goal-based investment plan has desired allocations across various stocks of different market capitalization.

No doubt multi-cap funds had become a preferred choice in recent times as it gave investors the option of investing across market caps through a single fund/category. But this new Multi-Cap allocation rule change (2020) is an important one from every investor’s MF portfolio perspective. And I am sure that the regulator has finalized this change with common investor’s interest in mind.

So we live with what is the new normal and if need be, make adjustments to our MF portfolios.