Overheating Fears: SEBI Considers Reviewing Rules for Mid and Small Cap Mutual Funds

March 14, 2024 Mutual Fund

The Securities and Exchange Board of India (SEBI), the primary regulator of the Indian equity market, has signalled a potential review of its existing rule for small-cap and mid-cap focused mutual funds, norms that mandate small and mid cap funds to invest at least 65% of their assets in equities. The action is being taken, amidst growing concerns about stretched valuations in the small-cap segment and potential risks for investors.

SEBI Chairperson Madhabi Puri Buch raised concerns on Monday, March 11, 2024, over the small- and mid-cap valuations, citing potential market manipulation and the possibility of a market bubble.

She said, “There are pockets of froth in the small and mid-cap space in the equity markets that have the potential to become a bubble and burst, affecting investors. On the overvaluation of small- and mid-cap stocks, SEBI’s data analysis shows that in some cases the valuation parameters are off the charts and not supported by fundamentals and appearing to be a case of irrational exuberance.”

In 2023, the Nifty Smallcap250 and Nifty Midcap150 have soared, outperforming the benchmark Nifty 50. These small-sized companies have been showing strong performance lately, recording significant gains and even contributing to the markets hitting a record high.

After small-cap mutual fund schemes attracted inflows of over Rs 41,000 crore in 2023, double the amount in the previous year 2022, SEBI took it as a sign of a bubble and asked mutual fund houses to put in place a framework to safeguard the interest of investors.

[Read: Rally in Mid Cap and Small Cap Funds: Should You Buy More or Sell Now?]

SEBI has recommended that trustees of mutual funds consider the appropriateness of lump sum investments in small- and mid-cap funds. The froth should not be allowed to continue accumulating, Madhabi Puri Buch, the chairperson of SEBI, stated on Monday. For fear of a segment overheating, a number of mutual fund institutions have ceased to accept lump sum investments in small cap schemes.

Earlier this month all asset management firms were required by SEBI to perform stress tests on small and mid cap funds and determine how long it would take to sell a fourth of their holdings in the event of a market crash and a rush for redemptions. This would indicate how fast investors will be able to liquidate their holdings during a market collapse.

Background

The Indian stock market has witnessed a significant rally in recent years, with small and mid-cap stocks leading the charge. This surge has been fueled by a number of factors, including:

• Increased Investor Participation:  Retail investor participation in the Indian stock market has seen a significant rise, with a particular focus on small-cap and mid-cap funds. This surge in inflows has contributed to increased demand for these stocks, pushing valuations upwards.
• Stable Interest Rates:  The prevailing stabilized interest rate environment has made traditional fixed-income investments less attractive, prompting investors to seek higher returns in the equity market. This has further fueled the rally in smaller companies.
• Higher Return Potential:  Compared to large-cap stocks, small-cap companies often have lower trading volumes, making them more susceptible to price swings and potential manipulation.

[Read: Can Small Cap Funds Deliver Big Returns Going Forward?]

These factors have raised concerns among regulators about potential overheating in the small-cap segment. Stretched valuations can lead to a situation where stock prices become disconnected from the underlying fundamentals of the companies, increasing the risk of a correction. This could significantly impact investors, particularly those who have invested in small-cap-focused mutual funds.

The Existing Rule and Potential Changes

Currently, SEBI regulations mandate that small-cap and mid-cap focused mutual funds invest at least 65% of their assets in these stocks. This rule aims to ensure these funds fulfil their investment objectives and expose investors to the targeted segment.

However, SEBI is now considering revising this rule due to concerns that it may be hindering effective risk management by fund managers.

The potential changes being considered by SEBI could include:

• Relaxing the Minimum Investment Threshold:  Reducing the mandatory investment requirement in small and mid cap funds could provide fund managers with more flexibility to manage risk. This would allow them to invest a larger portion of the corpus in large-cap stocks or other asset classes if they deem it necessary.
• Introducing Risk Management Parameters:  SEBI could introduce additional parameters that fund managers must consider when investing in small cap stocks. These parameters might include company fundamentals, liquidity, and valuation metrics. This would ensure that fund managers prioritise prudent investment decisions and mitigate risks for investors.
• Greater Flexibility in Investment Strategy:  SEBI could allow for more flexibility in the overall investment strategy of small cap and mid cap focused funds. This could allow fund managers to adopt a more diversified approach, potentially including exposure to other asset classes or thematic investment strategies within the small-cap universe.

The potential review of the SEBI rule is a positive development for the Indian mutual fund industry. It demonstrates the regulator’s commitment to protecting investors and promoting a healthy market environment. However, an open dialogue between SEBI, fund houses, and industry experts is crucial to ensure that any revised rule is well-defined, practical to implement and aligns with the interests of investors and the broader financial system.

In conclusion:

The revision of the SEBI rule for small cap focused mutual funds is a complex issue with far-reaching implications. Striking a balance between investor protection, market stability, and fund manager discretion will be key to ensuring a healthy and sustainable growth trajectory for the Indian small-cap segment.

This article first appeared on PersonalFN here