The Indian Mutual Funds industry is currently under the microscope as the Securities and Exchange Board of India (SEBI) demands a thorough assessment of small-cap and mid-cap funds. In an effort to manage risk, SEBI has advised mutual funds to limit large, one-time investments in small- and mid-cap funds and to reduce sales commissions. Following SEBI’s directive, the Association for Mutual Funds in India (AMFI) issued guidelines to mutual funds, emphasizing the need for policies to protect investors in small and mid-cap schemes. This includes moderating fund inflows and adjusting portfolios accordingly. This move reflects concerns over the rapid increase in investments in these funds and the potential consequences of mass withdrawals.

With a deadline set for March 15, mutual funds are tasked with evaluating liquidity and volatility within their portfolios. SEBI's recent directives have raised questions about the strategies of fund managers and analysts, particularly regarding the availability of viable stocks and the potential impact of regulatory oversight on investment decisions. The market reacted to these developments with a 2% drop in both small and mid-cap indices, highlighting the immediate impact of regulatory advisories on market sentiment. In today’s article we will look at SEBI’s directive, understand the impact on small cap and mid cap stocks along with what this means for your portfolio.

Surge in Small and Mid-Cap Fund Inflows Raises Regulatory Eyebrows

The Indian mutual fund industry has observed a significant shift in investment patterns in 2023, with mid-cap and small-cap funds experiencing remarkable inflows. Mid-cap funds attracted Rs 22,913 crore, while small-cap funds saw an even higher influx of Rs 41,035 crore. In contrast, large-cap funds faced outflows amounting to Rs 2,968 crore. This trend is coupled with strong performance in the respective indices; the BSE Small Cap index surged by over 23%, and the BSE Mid Cap index grew by more than 25% in the last 6 months. Despite these gains, concerns over valuation levels have emerged. The current valuations, while not overpriced, are considered rich, drawing attention from regulatory bodies.

SEBI has expressed worry over the substantial 92% increase in small-cap fund inflows during the first 10 months of this fiscal year, compared to the entire previous fiscal year. This surge has prompted SEBI to demand enhanced disclosures and investor protection policies from mutual funds. The asset under management (AUM) for small-cap funds soared by 89% to ₹2.48-lakh crore, and mid-cap funds witnessed a 58% increase to ₹2.90-lakh crore, as per AMFI data. Despite these increases, many small and mid-cap mutual fund schemes have raised their cash holdings, indicating difficulty in finding appropriately valued investment opportunities. The number of new small-cap stocks in mutual fund portfolios expanded from 428 to 506 by the end of December, whereas new mid-cap stock additions were minimal.

Industry Response to SEBI Advisory Highlights Prudent Measures

Experts believe that the advisory aims to ensure that AMCs have effective mechanisms in place for monitoring portfolio liquidity. This is to manage potential constraints on capacity and liquidity effectively, safeguarding both the industry and investors from unforeseen market volatilities. Several mutual funds, recognizing the importance of managing inflows to maintain market stability, have implemented restrictions on investments. For example, limits have been placed on Systematic Investment Plan (SIP) contributions in small-cap funds to manage growth responsibly. This approach is part of a broader strategy to prioritize investor interests and ensure the risk appropriateness of investments across various asset categories, including the volatile small and mid-cap segments.

On the performance front, the small-cap sector has attracted considerable attention due to its impressive returns, prompting a discussion on investment flows and liquidity challenges. The substantial interest in small-cap funds underscores the need for careful management to avoid "getting on the wrong side of things," as the liquidity constraints in this segment can present unique challenges. Regulatory advisories are viewed positively within the industry, enhancing transparency and confidence. The call for greater transparency and risk management, including the advisory to curtail risks in small-cap funds, is seen as a step towards ensuring a more stable and informed investment landscape.

AMFI Directive: Mutual Funds Directed to Enhance Transparency and Manage Risks

Large mutual fund houses have already taken steps to limit inflows to safeguard investor interests. Examples include the SBI Small Cap Fund, HDFC Small Cap, and Nippon India Small Cap Fund, which have imposed restrictions on SIP amounts and maintained significant cash and treasury-bill investments. In response to SEBI 's directives, the Association of Mutual Funds in India (AMFI) has called for mutual funds to improve disclosures on these schemes. AMFI's communication stresses the need for fund houses to adopt measures like moderating investment inflows and rebalancing portfolios to prevent investor disadvantages, especially from those exiting early.

Moderating Inflows: Optional but Strategic

The decision to moderate inflows into small and mid-cap mutual funds is left to the discretion of fund houses. While some, like SBI Mutual Fund, have already ceased lumpsum investments to manage market impact, others, particularly newer and smaller funds, remain open to new investments. Trustees are required to approve these policies and disclose them on the AMC websites within 21 days.

1. Risk Assessment for Hypothetical Liquidation: Funds must report on the risks associated with a hypothetical liquidation under stress, such as in scenarios of 10% or 30% redemption.

2. Portfolio Concentration: This involves detailing the concentration levels within the fund's portfolio.

3. Investor Concentration: Funds are to report on the assets contributed by their top five and top ten investors, highlighting potential reliance on significant investors.

4. Portfolio Composition: Detailed breakdowns between investments in large, mid, small-caps, and cash.

5. Valuation Metrics: Disclosure of valuation parameters, including the price to earnings multiple and price to book value.

6. Investment Risk Metrics: Funds must share investment risk metrics, such as the Sharpe ratio, to offer insights into the risk-adjusted returns of the portfolio.

The move comes amid growing apprehensions about the sustainability of small and mid-sized funds in the face of potential market downturns. SEBI 's ongoing scrutiny includes stress tests to assess fund resilience.

What does this mean for you as investors?

Experts argue that the size of a fund does not inherently affect its performance if it operates within its established risk frameworks. The real challenge emerges when a fund's size forces it to venture beyond its liquidity or market capitalization comfort zones, potentially compromising its investment strategy. Large fund houses, benefiting from expanded research teams, can delve deeper into a broader array of stocks, mitigating risks associated with liquidity crunches. Diversification across a wide range of stocks can provide a buffer in volatile market conditions, ensuring stability even in the face of market pressures.

For investors, the current market scenario underscores the importance of a strategic approach to investing in smallcap and midcap funds. Experts recommend maintaining a long-term investment horizon of at least 3-5 years and favoring a staggered investment approach over lump-sum contributions. This caution stems from the significant outperformance of the small-cap segment in recent times, leading to stretched valuations and heightened risks.

The difference in returns between the small-cap index and the Nifty 50 over the past year has been historically high, signaling the need for investors to exercise caution. Given the current market dynamics, investing in smallcap and midcap funds requires a careful consideration of risk and return, with a focus on long-term growth prospects rather than short-term gains.

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