Sebi’s recent circular asset allocation framework for multicap mutual funds has triggered small stocks. The Nifty Small-Cap 100 Index jumped 5.2% in trading on Monday, nearly 8% below its pre-covid highs. Analysts say this is a sentiment boost that will lift stocks only in the short term. But given that valuations have soared above pre-covid levels, it can take a long time for many stocks to recover from pandemic profitability.
Indeed, Sebi’s circular that requires multi-cap funds to allocate at least 25% of their portfolios to large, mid, and small caps, each may see some loss of their funds. Almost 74% of the almost ₹1.4 trillion invested in multi-cap funds are invested in large-cap funds, making them quasi-large-cap funds. While SEBI clarified that fund houses have some options to re-evaluate the mandate of these funds, the markets have already started ramping up small-cap stocks.
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“It is not a classification of stocks like the one that happened in January 2018. This time it is just a category of mutual funds. The impact will be short-lived. There is a lot of excitement among traders and investors operating in small and mid-cap companies today, as they would be trying to anticipate moves and get ahead of mutual funds. This will last a few days, “said Sahil Kapoor, market strategist at Edelweiss Securities Ltd.
The best multi-cap funds with ₹1 trillion assets under management have less than single digit exposure to small-cap stocks. Keep in mind that converting a portfolio of this size into small and mid-cap stocks is not easy. First, small and mid-cap stocks have low liquidity, and therefore the implementation of these measures will have a high impact cost for fund houses.
Also, it will take a long time to meet the requirements given the low market limits. “At an aggregate level for all BSE-500 stocks that are currently considered ‘small cap’, it could take 2-3 months of continuous purchases for multi-cap schemes to achieve the required rebalancing. This is assuming that MFs buy the 250 small-cap shares on BSE-500, and also assuming that MFs can get 30% of the delivery volumes of these shares every day, “analysts at JM Institutional Equities said in a note to customer.
In reality, fund houses are more likely to approach SEBI for the reorganization of the scheme given the low liquidity in small-cap stocks. SEBI issued a clarification on Sunday noting that fund houses may take reorganization measures, such as reclassifying funds as large-cap and merging with other existing funds. Analysts expect at least 55% of multi-cap funds to use this route in the coming months.
Also, mid-cap and small-cap valuations are stretching. The impact and disruption of the pandemic for small and mid-caps have been high, especially in the case of manufacturing. Valuations of the CNX Nifty Small-cap 100 index have already crossed their pre-covid highs with the price-earnings multiple at 33 times earnings. In February, the PE stood at 27 times current earnings, data from the National Stock Exchange show.
“The earnings pool for small and mid-caps has shrunk, and earnings have not kept up with large caps. It appears to be more of a short-term sentiment boost, rather than a material difference over a longer period of time, “Kapoor said.
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