SEBI Now Trains Its Guns On Sectoral And Thematic Funds

The latest consultation paper by Securities and Exchange Board of India on the skin in the game proposals for AMC employees has an unusual proposal—extension of stress test disclosure publicly of all equity schemes, excluding close ended and interval schemes.

So far, the markets regulator has mandated monthly disclosure of stress tests in small and midcap schemes on the AMFI and AMC website. The disclosure requirement followed the steep run-up in small and midcap shares and surge in inflows into these schemes. Since then, there has been some return to sanity in the flows into these schemes. And what's more, the recent correction in small and midcap stocks have ensured that returns are more moderate.

But now, flows into sectoral and thematic schemes have increased to such an extent that they are attracting over one-third of the net equity flows on a monthly basis.

The key flexibility given to the fund managers in sectoral and thematic schemes, which often leads to outperformance, is also the biggest risk factor for investors. These schemes do not have a cap on stock exposure, unlike most actively managed equity schemes, which have a 10% limit per stock. For example, at the end of September, the HDFC Defence Fund had a 19.5% allocation to Bharat Electronics Ltd. and 17.9% to Hindustan Aeronautics Ltd. To be clear, this is not a judgement on the strategy of the scheme.

However, this kind of absence of exposure caps puts investor money at risk, as the impact on net asset value is directly tied to the extent of exposure and degree of volatility. As a hypothetical illustration, if BEL shares were to fall more than 5% in a week, it would have an outsized impact on the NAV of the HDFC Defence Fund. Do note that the HDFC MF scheme is simply being used as an illustration and many other sectoral schemes have similar strategies.

Also, during exceptional redemption events, the scheme will have to offload its most liquid stocks first. This could lead to severe drawdowns in a large portion of the portfolio.

Though the results are not public, it would not be surprising if some sectoral schemes have very large number of days for liquidation as measured by SEBI's stress test.

Retail investors' net inflows into equity schemes since April 2023 stood at Rs 3.88 lakh crore, according to Association of Mutual Funds of India. These inflows have firmed up further due to increase in number of sectoral and thematic schemes that many fund houses have been launched.

Since April 2023, the mutual fund industry has launched 68 new fund offers under the sectoral and thematic category, that is 60% of the total active equity NFOs launched since April 2023.

Retail investors' net inflows into sectoral and thematic schemes since April 2023 has hit Rs 1.42 lakh crore. That accounted for 37% of the total net inflows (Rs 3.88 lakh crore) since April 2023. The inflows have been so dramatic that sectoral and thematic is now the single largest actively managed equity category, having raced past the flexicap category a few months back. As of September end, this category had assets under management of Rs 4.67 lakh crore.

With so much of flows into the sectoral and thematic schemes, it is no surprise that the regulator wants the stress test disclosure for sectoral and thematic funds as well.

But tucking it in into a skin in the game consultation paper came in as a bit of a surprise.