Diversification rule ‘is good for funds’

multi cap investment diversification

The Securities and Exchange Board of India (SEBI) in 2017 had mandated multi-cap funds to allocate its investments to the tune of 65% in equity or equity-related instruments in either large, small or mid-cap funds.

However, the SEBI, through its circular dated 11 September 2020, has altered the allocation requirement of multi-cap funds. They are now required to diversify their investments to the tune of 25% each in large, small and mid-cap funds.

Currently, the investment portfolio of most multi-cap funds is concentrated in either large-cap or mid-cap funds, thereby disregarding the value of small-cap funds. The rigidifying of the investment norms will ensure that the multi-cap funds stay true to their title and invest equally in each of the three types of funds, respectively.

Multi-cap funds like HDFC Equity, Kotak Standard Multicap, Motilal Oswal Multicap 35 and others have most of their investments lying in large-cap funds. The gap in the investments between large-cap funds and small-cap funds is wide, and the new norms will ensure that the existing gap is bridged.

However, this can reduce the flexibility exercised by fund managers in managing the investment portfolios of these funds. Although the new norms can significantly increase the valuation of the small-cap and mid-cap funds, large-cap funds might take a hit in the process. Further, increased exposure of large-cap funds to small-cap funds might cause high volatility in the overall net asset value of such funds. Consequently, the risk profile of the funds will change substantially, and the fund managers must be well equipped to handle the same.

The SEBI has clarified that the said norms have been made keeping in mind the true-to-label and appropriate benchmarking. Also, it has stated that the rebalancing of the portfolio by multi-cap funds can be done according to the needs of their unit holders. While Kotak Standard, India’s largest multi-cap fund, was already contemplating the conversion of its multi-cap funds into a thematic fund, or merging its multi-cap fund with the large-cap funds, the SEBI clarification in this regard has recognized that the funds will be allowed to revamp their funds in the manner proposed by Kotak. Additionally, the SEBI has given until 31 January 2021 to comply with the said norms, depicting its intent of avoiding any disruption to market stability.

Overall, the new rules seem to be a welcome move for the small-cap funds and mid-cap funds, since there will be a tremendous wave of liquidity, i.e., expected infusion of US$5 billion in such funds. Further, the diversification of funds will not only help the small-cap funds to realize their true potential, but also help the investors who were holding their investments in such funds for a long period in speculation of true price discovery.

However, the impact of the rules on large-cap funds remains to be seen. The fact that the SEBI has provided flexibility while complying with the rules ensures that there will be minimal or no disturbance during the diversification process. Thus, the new rules will prove to be fruitful to the mutual funds industry in the long run.

Eshvar Girish
School of Law, Christ (deemed to be university)


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