Overheated Small, Mid Caps: Mutual Funds Say All Investors To Be Treated Fairly

Market regulator Securities and Exchange Board of India has asked mutual funds to get cautious amid concerns in valuations and rally in the small-cap space, asking them to follow certain steps to ensure investor protection.

The mutual fund companies have been asked to put steps in place to ensure that investors are protected from the impact of the first-mover advantage of redeeming investors.

What is the first-mover advantage? Simply put, it means that investors redeeming first get an advantage of a higher NAV during the time of redemption and those redeeming later get a lower NAV.

The market regulator wants to ensure that such circumstances do not arise, said multiple industry leaders to whom NDTV Profit spoke. "The steps are to ensure there is a framework in place and as of now, there does not seem to be a problem. It is more of a pre-emptive measure," said one of the persons quoted above.

Asset management companies and fund managers have also been asked to consider moderating flows and rebalancing portfolios.

"The idea is to put responsibility on the AMC to treat all investors fairly," said the head of a leading mutual fund on the issue of the first-mover advantage. "They don’t want quality shares to be sold in the market to fund redemption and left with an illiquid portfolio. This does not mean we put a limit on redemption."

The mid- and small-cap category schemes have witnessed huge inflows recently, with some funds topping the active fund list by assets under management.

HDFC Midcap Opportunities and Nippon Smallcap Fund have been among the top five funds, according to Morningstar data, with their average AUM rising to over Rs 40,000 crore and Rs 30,000 crore, respectively, as of December 2023.

Nippon Mutual Fund, however, stopped lump-sum inflows into its small-cap schemes last year on the back of unprecedented inflows into categories.

"Fund managers need to keep the portfolio in more liquid names across market caps. If the view is bearish, each fund manager can alter his or her cash levels," said another top mutual fund chief executive officer.

Small-cap funds have a minimum requirement of 65% of allocation under the category, according to the SEBI guidelines. Most of the large AMCs' funds have around 70–75% of such allocations, according to a mutual fund's chief investment officer.

"Funds should be marked to NAV and valuation guidelines are strict. At best, every fund maintains like 30% in larger-cap stocks to provide exits. And even that doesn't work if you need 30% all the time... Because every redemption means you will sell some small-cap or the other," Deepak Shenoy of Capitalmind said on platform X. "Either way, smallcaps and midcaps must end up getting sold somewhat to accommodate this."