[Divya Rau is a final-year law student at Jindal Global Law School]
The Securities Exchange Board of India (“SEBI”) issued new guidelines regarding asset allocation by multi-cap funds on 11 September 2020 (“New Circular”). A multi-cap fund refers to “an open ended equity scheme investing across large-cap, mid-cap, small-cap stocks”. Large-caps refer to the top 100 firms by market capitalisation, mid-caps to the 101st to 250th company while small-caps refer to entities from the 251st company onwards. The New Circular prescribes a minimum investment of 75% of total assets in equity. It further mandates that, of the minimum 75%, a minimum of 25% must be invested in large-cap stocks, mid-cap stocks and small-cap stocks separately. The Circular must be complied within one month of the publication of the list of stocks by the Association of Mutual Fund Houses in India (“AMFI”) i.e., by 31 January 2021.
SEBI followed the Circular with a clarification dated 14 September 2020 in response to the concerns raised by multi-cap funds and investors alike. The clarification provides alternative routes of compliance, in addition to rebalancing of portfolios such as a switch to other schemes, merger with large-cap schemes or a conversion to another scheme category altogether. It is important to note that there are 35 multi-cap funds with assets under management valued at Rs. 1.47 trillion. The purpose of this post is provide a framework in order to analyse the purpose and impact of the New Circular.
Legal Framework of Mutual Funds Schemes
Mutual Funds are under the purview of SEBI and governed by the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 (“Regulations”). To broadly understand the structure, a mutual fund is a trust in accordance with the Trusts Act, 1882, established by a sponsor. The role of the sponsor is similar to that of a promoter of a company. The trustees of the mutual fund are tasked with ensuring regulatory compliance of the fund, while the custodian holds the securities of the schemes of the fund in its custody. The asset management company (“AMC”) manages the schemes of the mutual fund. Chapter II of the Regulations deals with registration of a mutual fund with SEBI.
Regulation 28 of the Regulations requires that all schemes offered must be approved by the board of trustees. According to Regulation 29, the offer document to be filed with SEBI must contain appropriate disclosures so that investors can make an informed choice. Circulars issued by SEBI that govern mutual fund schemes are issued under section 11(1) of the Securities and Exchange Board of India Act 1992, read with regulation 77 of the Regulations. A Circular issued by SEBI dated 6 October 2017 (“Previous Circular”) concerns rationalization and categorization of mutual fund schemes. It aims to ensure uniformity in schemes offered by various funds. It provides a description and characteristics of the ten equity mutual fund schemes amongst other types of schemes like debt and hybrid that are permitted by SEBI. All schemes offered by any mutual fund must comply with the characteristics of those listed in the Previous Circular. The equity schemes are not restricted to a certain kind of stock, while a minimum requirement of investment in equity is generally prescribed. For example, a large-cap fund must have a minimum of 80% of total assets invested in large cap. However, the remaining 20% is not within the purview of SEBI scrutiny and is dependent on fund managers. The title or name of the equity scheme indicates the kind of stock that represents the predominant investment of that fund or the strategy deployed in investing.
In terms of the Previous Circular, multi-cap funds were subjected to the requirement that a minimum of 65% of total assets be invested in equity. The Previous Circular placed only a general minimum equity investment limit and the actual asset allocation in large-cap stocks, mid-cap stocks and small-cap stocks were not within the scope of SEBI. The New Circular, therefore, alters the Previous Circular by raising the equity investment minimum to 75% and providing mandatory investment floors in large-cap, mid-cap and small-cap stocks for the multi-cap category.
‘True to Label’ Reform: A Brief Insight into SEBI’s Approach
In the New Circular, SEBI is mandating a proportionate or balanced allocation of funds in large-cap, mid-cap and small-cap stocks. The New Circular aims to minimise the discrepancy between categorisation and actual functioning of multi-cap funds, thereby attempting to minimise the confusion of investors. It embodies a ‘true to label’ reform measure, mandating that such funds must be ‘multi-cap’ in spirit and name. It is reflective of SEBI’s attempts to protect investor interest through the lens of transparency and informed choice amongst the investors in the market. It may be perceived as an attempt to nudge multi-cap funds to conduct their investments in the spirit of “multi”, which is in consonance with the advice provided in the Previous Circular.
Multi-cap funds tend to have a significantly larger proportion of total assets invested in large-cap as compared to mid-cap and small cap stocks. The New Circular focuses on diversification, targeting multi-cap funds that do not have a balanced allocation. For example, Kotak Standard Multi Cap Fund, the largest multi-cap fund scheme in India, has allocated assets of nearly 70% in large-cap, 22% in mid-cap and a mere 1.5% in small-cap stocks. As stated above, due to the absence of any mandatory investment in large-cap, mid-cap and small-cap stocks, managers of the fund had the discretion to invest in stocks across market caps to varying proportions, provided that the previous 65% equity investment minimum was met. Therefore, multi-cap funds are often “multi” in name, but not in spirit, which highlights a regulatory gap that SEBI is attempting to cover.
The New Circular relies on the assumption that investors in multi-cap funds desire a balanced allocation rather than maximization of returns across all market-caps. While most multi-cap funds have not yet announced their chosen manner of compliance, the new guidelines are expected to result in an outflow of approx. Rs 35,998 crores due to the sale of large-cap stocks and a deployment of approximately Rs. 13,145 crore in mid-cap stocks and Rs. 27,933 crores in small-cap stocks. This indicates that large-cap stocks might be off-loaded, while mid-cap and small-cap stocks will see an increase in demand which is likely to improve sentiment and activity in mid-cap and small-cap entities. However, the sudden surge in demand mid-cap and small-cap stocks may lead to artificial high prices, which are likely to subside when the 2021 deadline arrives, thereby harming investors in the long-run.
SEBI’s main concern appears to be that the label on the box differs from its contents. In order to align the label and the contents, there are two possible solutions. Either the content or the label must change. In opting to alter the content, SEBI is steering on the side of investor protection, rather than ease of compliance for multi-cap funds. SEBI maintains that it is open to examining any proposals it receives, demonstrating a flexible approach, in order to maintain market stability.
For multi-cap fund schemes, the significant impact of the New Circular is the curbing of active management powers in the name of investor protection. Multi-cap funds offer a wide discretion on mutual fund managers. For example, Kotak Standard Multi-Cap Fund has allocated nearly 70% of its total assets in large-cap stocks. However, if the mutual fund manager is of the opinion that mid-cap stocks may out-perform large-cap stocks in the next quarter, it can alter the proportion invested across all market-caps. The regulator has allotted clear minimum thresholds under the new Circular, thus limiting the strength and scope of discretion that these funds may exercise with respect to the proportion of investment across all market caps vis-à-vis the changing market conditions. However, whether the New Circular actually interferes in the performance of a fund is yet to be seen.
– Divya Rau