SEBI Caution On Small- And Mid-Cap Funds May Drive Flows Into Large Caps

The market regulator's advisory asking mutual funds to protect investor interest amid "froth" building up in small and mid caps will make investors assess risks and drive more flows into large caps, according to market participants.

This initiative will prompt individuals to contemplate the risks associated with this sector, according to Balasubramanian, managing director and chief executive officer at Aditya Birla Sun Life AMC Ltd. "SEBI is actively monitoring and endeavouring to enhance the risk management practices."

Among the steps suggested, asset management companies and fund managers have been asked to consider moderating flows and rebalancing portfolios, according to an internal letter sent by industry body the Association of Mutual Funds in India to mutual fund trustees. The letter, not publicly available, has been seen by NDTV Profit.

The regulatory scrutiny arises from concerns that these share segments are excessively inflated, while investor flows into these schemes persist without any signs of slowing down.

"The viable option at their disposal is to either implement a restriction on new entries or allocate 35% of their portfolio into more liquid instruments. However, even this approach poses challenges and may not offer a comprehensive solution during a crisis,"  Deepak Shenoy, chief executive officer at Capitalmind, said.

During the year 2023, mid-cap funds witnessed inflows worth Rs 23,346.15 crore, while small-cap schemes attracted inflows amounting to Rs 42,036.62 crore. Meanwhile, large-cap funds witnessed an outflow of 2,397.06 crore in the past 12 months.

"A significant development is the communication from SEBI to AMFI suggesting that mutual funds set up a framework for protecting investors in mid- and small-cap funds," said VK Vijayakumar, chief investment strategist at Geojit Financial Services. "Sustained flows of retail money into these funds have made their valuations excessive and difficult to sustain. More mid- and small-cap funds are likely to impose restrictions on lump-sum investments in the mid- and small-cap  schemes." 

This will benefit the large caps, which are relatively valued lower now. The correction in the broader market is likely to continue, Vijayakumar said.

There is no margin of safety in small- and mid-cap investments despite the positive growth lately, according to Vinod Karki of ICICI Securities Ltd.

The rally in small- and mid-cap stocks had occurred previously, notably after the Bharatiya Janata Party's victory in the 2014 Lok Sabha election, Karki, senior vice president of equity research at ICICI Securities, told NDTV Profit.

At that time, the mid- and small-cap index saw a rapid increase within a few months, making it expensive vis-à-vis the large caps. This bubble eventually bursted in 2018, he said. "These higher valuations can persist for a longer duration if growth continues to support them."

Exuberance in mid- and small caps is a key concern for Indian equities and may limit their prospective returns vis-à-vis large caps, ICICI Securities said in a Feb. 16 note.

Large caps are reasonably valued and are not on the expensive side, Argal, senior vice president and portfolio manager at Franklin Templeton, told NDTV Profit. Mid caps find themselves on the higher valuation spectrum, he said.

After the announcement, the broader markets were trading in red. Small-cap fell over 1% and mid cap was trading 0.77% lower.