Restructuring of Multi-Cap Funds as regulated by SEBI

[Last Update: 27-Nov-2020]
Multi-Cap Funds have been a hot topic of discussion off-late. SEBI has regulated how multi-cap mutual funds can be operated. Let us look at the details.

What are Multi-Cap Funds

These are diversified equity mutual funds that can invest in stocks across market capitalization. In other words, they are market capitalization agnostic. That is, their portfolio comprises of large-cap, midcap as well as small-cap stocks. 
The fund manager has the flexibility to move your funds across any of these categories of stocks depending on the market situation, with an aim to give you maximum possible returns. 
They are relatively less risky compared to a pure mid-cap or a pure small-cap fund and are suitable for not-so-aggressive investors.
[Further Reading: What are Large, Mid and Small Cap Funds]

What is the new SEBI norm on Multi-Cap Funds?

SEBI (Securities and Exchange Board of India), which is the prime regulator for markets in India, has specified the following:
1/ Multi-Cap schemes are not true to the label.
2/ Though these schemes invest across different cap funds, the ratio maintained ins lopsided, which was not the intent of launching this category of multi-cap funds.
3/ Multi-cap schemes should have a minimum of 25 percent allocation each to large-caps, mid-caps, and small-caps. 
This essentially means that, as an example, the fund house or the fund manager can decide to go to a maximum of 50% on Large Cap funds and the remaining has to be split between mid-cap and small-cap funds.

Objective of this SEBI Norm

SEBI says that all mutual fund schemes should be true-to-label and should have appropriate benchmarking.
And no one would disagree with this, otherwise, it is very common for the investors to get mislead.

What triggered this SEBI Norm?

1/ While SEBI defined multi-cap funds as those that invest across large-cap, mid-cap, and small-cap stocks, the regulator didn’t specify any minimum allocation for any of these market caps back then.
2/ Some multi-cap schemes have skewed portfolios, with over 80 per cent of investment in large-cap stocks, thus making the fund akin to a large-cap scheme, and some multi-cap schemes have near-zero or insignificant asset allocation to small-cap companies.
3/ The data shows that few of the schemes have near nil allocation to small-cap companies and 9 out of the 35 multi-cap schemes invested less than 5 per cent into small-cap companies.
Considering so many anomalies, a need was felt to review the scheme characteristics of multi-cap schemes and take necessary steps to clearly distinguish multi-cap schemes from other categories of schemes.

What size of Multi-Cap we are talking about?

1/ As of August 31, 2020, the asset size of multi-cap funds stood at Rs 1.46 lakh crore, which makes it the second-largest equity category.
2/ Out of this, if the SEBI order has to be implemented, and the 25-25-25 ratio needs to be maintained at all times, the Mutual Fund industry will have to churn around Rs 40,000 crore worth stock in their portfolios. Rs 40,000 crore will move, most likely, from the large-cap to mid-cap and small-cap companies.
3/ Kotak Mutual Fund's Standard Multicap Fund is the largest fund in the respective category holding assets over ₹29,000 crores. The scheme has maintained its large-cap allocation to around 70%, which, in such a case, has to be brought down by at least 20%.

Immediate Possible Implications

1/ This new norm had earlier built-up expectations that small-caps could start to see a sharp rally as fund managers would now be forced to rotate large positions from multi-cap schemes to this segment of the market. But that may not happen because of the other possible options to handle this norm.
2/ Fund houses say that adding small-caps in multi-cap portfolios in large quantity is not favourable as this can significantly shoot up the risks for unitholders. 
3/ Meanwhile, there were also fears that large-cap stocks could correct massively as most multi-cap schemes had become large-cap heavy. According to data from Morningstar, of the 35 multi-cap funds, 32 had over 50 per cent allocation to large-cap stocks. Of this, 28 schemes had between 65 per cent and 92 per cent large-cap allocation as of August 31, 2020.

Update : 27-Nov-2020
As of SEBI circular dated 6th Nov 2020 as per the link below, SEBI introduced a new type of fund by the name of 'Flexi-Cap' funds which can have small, mid, and large-cap funds in any proportion, precisely the same way Multi-Cap funds were operating until now.

SEBI Circular on Flexi-Cap Funds --> SEBI Circular 

What are the other options with Fund Houses?

Instead of keeping the fund movement from large-cap to mid-cap or small-cap as the only way out, SEBI has given some freedom to Fund Houses. Here are a few options they have and their possible implications:

1/ Merging schemes with other large-cap funds
The fund house has the freedom to merge the multi-cap scheme with its own large-cap scheme. Once merged into large-cap, the 25-25-25 norm remains no more applicable. However, merging or changing the scheme category might create its own set of problems. It is not an easy process at all.
2/ Re-positioning the schemes as large- and midcap schemes
Since the majority of the funds in the current Multi-Cap schemes are large-cap and the second-largest are mid-cap, then the other option is to merge the multi-cap scheme with its own Large+Mid-cap scheme.
3/ Facilitating unitholders' switch to any other scheme.
MF Houses can also give the option to the unitholders to switch the funds to any other scheme of their choice within the same fund house without any charges.

What out of the box ideas MF houses wish to propose SEBI?

Mutual Fund (MF) industry executives are also set to meet SEBI to present a range of options, including :
1/ Scheme mergers
2/ Re-launching multi-cap funds as thematic funds
3/ Asking for a 'flexicap' category.
Fund managers had pointed that NSE 500, which is a benchmark for multi-cap schemes, also had just about six per cent weightage towards small-cap stocks and 14 per cent to mid-cap stocks.
4/ Seeking more time from Sebi for the implementation of the new norms.

Deadline for Fund Houses to implement this change?

SEBI wants the new norms to be implemented by February 28, 2021. The mutual fund industry also wants SEBI to consider extending this deadline to at least one year.

Summary

1/ I personally see Flexi-cap as a very interesting option  (somewhat like a dynamic bond fund on the debt side that gives the power to fund managers to move within company sizes) as a viable solution. But Sebi has given enough options to fund houses to deal with their existing multi-cap funds. 
Update : 27-Nov-2020
Flexi-Cap has been introduced by SEBI as a new fund category and in all likelihood, the Multi-Caps will get rebranded as Flexi-Cap Funds.

2/ If the fund houses re-adjust to the new norms rather than aligning their funds differently, the Multi cap funds will become riskier but may offer higher returns - because of the increased presence of mid and small caps. 
3/ For now, as an investor, stay put in your Multi-Cap mutual funds and wait for strategies from your fund house to unfold. When you get clarity on how these schemes are going to be positioned, and if the risk profile of the scheme is really changing, you can make a call, of course, in consultation with your financial advisor.

History
18-Sep-2020: Original Post
27-Nov-2020: Introduction of Flexi-Cap Funds by SEBI

Regards

Manoj Arora
Official Website