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In a recent dialogue between the Association of Mutual Funds in India (AMFI) and the Securities and Exchange Board of India (SEBI), AMFI has issued a directive to asset management companies (AMCs), urging them to proactively protect investors with significant exposures to small-cap and midcap funds. This directive follows SEBI’s expressed concerns regarding market “exuberance” in smaller stocks. AMFI has instructed fund trustees and unitholder protection committees to devise and implement protective measures, mandating that these measures be announced on their respective websites within 21 days.

Additionally, AMFI has tasked fund houses with conducting stress tests on their mid- and small-cap schemes using data from the previous month, with disclosure of the findings required before March 15. This action is in response to SEBI’s apprehensions regarding excessive speculation in these schemes, even as major fund houses have been limiting inflows due to challenges in finding investment opportunities at appropriate valuations. Going forward, AMFI and asset management companies will be obligated to publish the stress test results of these schemes on their websites within 15 days following the end of each month. This stress test reporting initiative is set to commence on March 15, with analysis of February’s data serving as the baseline.

Balancing Act Amid Uncertainty

SEBI has voiced concerns about the growing enthusiasm in small and mid-cap stocks recently. As of December, the assets under management (AUM) of large-cap funds totaled ₹2.96 trillion, while mid-cap and small-cap funds reached ₹2.82 trillion and ₹2.34 trillion, respectively. Notably, over the past year, small and mid-cap schemes have seen inflows of ₹40,000 crore and ₹20,000 crore, respectively, whereas large-cap funds have witnessed outflows of ₹2,000 crore. This indicates a noticeable shift towards riskier investment options.

Additionally, valuations have surged significantly. The current P/E ratio of the mid-cap index, at 32.39x, is only slightly lower than the trailing five-year average of 32.80x, while the small-cap index’s P/E ratio stands at 28.41x, considerably higher than the five-year average of 19.29x. Investors have been attracted to these schemes due to their impressive returns. Over the past year, the mid-cap and small-cap indexes have yielded returns of 62% and 65%, respectively. Moreover, their compounded annual growth rate (CAGR) over five years stands at a healthy 22% and 27%.

Both SEBI and AMFI face significant challenges in addressing this situation. However, SEBI’s proposal for “proactive measures” may not necessarily be the most prudent approach. Implementing strategies such as artificially curbing inflows or mandating fund managers to maintain substantial cash reserves by selling off their portfolios to cater to potential redemptions could potentially harm the market for two key reasons.

There are two primary concerns with potential regulatory actions on certain stocks held by mutual funds. First, any forced selling or cash shortages among fund managers could trigger significant price drops in these stocks. Second, interfering with the market’s natural course violates a fundamental principle. Moreover, such actions might signal dissatisfaction with stock valuations or fund inflows, leading to increased investor unease and potentially prompting profit-taking redemptions.

The private mutual fund sector, having operated for over three decades, should allow investors to mature in their decision-making. While initial guidance is beneficial, excessive intervention should be avoided. Instead, regulatory bodies should reassure investors by affirming their commitment to market principles and safeguarding investor interests. One positive step is the requirement for comprehensive data disclosure, enabling investors to make informed choices. However, reports suggesting potential temporary exit load allowances are concerning. Investors should not face additional costs for managing their investments. The long-standing disclaimer about market risks should remain meaningful, underscoring the importance of informed decision-making..