Many investors who held small cap stocks in their portfolio were pleasantly surprised when they read the circular issued by Securities Exchange Board of India (SEBI) on asset allocation of multi-cap schemes on September 11, 2020. The Capital Market regulator has advised fund managers to invest minimum 25% in each large, mid and small cap stocks. At a time when most multi-cap funds have invested a large part of their money in large-cap stocks, this directive is expected to change the portfolio mix and the risk-reward associated with multi-cap schemes.
According to the Association of Mutual Funds in India’s monthly data release, ₹1.46 lakh crore are invested in multi cap schemes as on August 31, 2020. In the past, over one and three year period ended September 11, 2020, large-cap and multi-cap schemes delivered 3.8% and 5.17% respectively. In the same period mid-cap funds and small-cap funds delivered 10.7% and 12.46% respectively. Though there was a narrow rally in 2018 and 2019 led by handful of large cap stocks, most of the mid & small cap stocks were beaten down due to a slowing economy. However, the mid and small cap stocks made a strong come back in the latter half of the pull-back rally of 2020 due to relatively attractive valuations, sector rotation and large cap stocks getting into over- bought zone.
A look at the portfolio of most Multi-Cap funds shows that majority of these schemes have a large-cap bias. Ten schemes (with AUM > ₹5000 crore) together manage assets worth ₹1.2 lakh crore. These schemes have ₹90177 crore invested in large cap stocks. For example, HDFC Equity Fund and Axis Multi-Cap Fund have allocations exceeding 80% in large cap stocks respectively.
When the categorization of mutual funds was announced in October 2017, the market regulator defined a multi-cap scheme as an equity scheme that invests minimum 65% of the money in stocks and related instruments. There was no prescription about market capitalization of stocks it could invest into – in other words a fund manager could invest in stocks across market capitalization based on his views of a particular sub-asset class. No wonder, many fund managers took to large caps in a market with narrow large-cap leadership. Being in large-cap stocks ensured sufficient level of liquidity and adherence to quality and helped them to reduce the risk associated with mid and small cap stocks in their portfolio, particularly in a black swan Pandemic environment.
However, according to the new norm, schemes have around four months to rebalance their portfolios and make it ‘true multi-cap– with minimum 25% each in large, mid and small cap stocks’. This directive will make the portfolios of Multi-Cap schemes spread evenly across the capitalization curve, as well as align the portfolios as “True to their Label”. If the economy recovers fast and catches onto growth momentum then such portfolio with relatively high allocation to mid and small-cap stocks can generate high returns as mid and small-sized companies can offer outsized returns in a bull market phase. However, the same approach can hurt as these mid and small companies are more likely to get negatively impacted in an economic contraction and de-growth environment. Apart from adjusting the portfolio to the new allocation norms, there can be other options which individual fund houses may opt based on their view of how these sub asset classes may perform in the future. In case the view is Risk-on due to global liquidity and dollar weakening, then re-balancing the portfolio as per the guidelines may result in higher alpha as mid/small caps may tend to outperform their larger peers in an extended bull market phase. However risks on the downside, like slow down in growth, geo-political escalation, prolonged recession due to the Pandemic, rising inflation may force Fund Managers to prefer to stick to their current asset allocation. In such cases the Fund managers may take measures like – re-categorization or merge with other schemes to broadly mimic their present sub-asset allocation, offer switch out to other schemes, from a risk-return optimization perspective.
As regards investors, taking a bet on near term market direction is never advisable due to multiple moving parts like heightened volatility ahead of the US elections or weakening corporate earnings’ announcements, rising geo-political tensions and a possible second wave of Covid19 pandemic. Given the reasonable time period for adjusting to the new allocation within the category, investors may choose to re-assess their risk profile and based on their asset allocation needs and objectives decide on their investments, and avoid any knee jerk reaction. They need to evaluate the actions taken by the respective Fund managers to optimize their portfolio risk vs return within the overarching Regulatory objective to safeguard their interests, at all times. Investing in a basket of Mutual Funds across the risk return spectrum may be a better option for long term wealth creation.