India’s securities regulator has hurt smaller companies with its recently-implemented mutual fund rules

• In October 2017, the Securities and Exchange Board of India enforced rules to make mutual-fund categories more uniform and standardised. For example, large-cap stock schemes had to comprise at least 80% large-cap stocks.
  
• The rules were meant to declutter the mutual fund industry and improve investor choice, but instead they diverted inflows from small-cap companies by reducing the exposure of large-cap schemes to smaller stocks.
  
• According to data from Prabhudas Lilladher, small-cap stock schemes recorded a net outflow of ₹220 million between January and June 2018, compared to a net inflow of ₹56.5 billion a year ago.
  

When the Securities and Exchange Board of India (SEBI) order the reclassification and rationalisation of open-ended mutual fund schemes in October 2017, its intentions were clear. It wanted to declutter the mutual fund industry by implementing procedures for standardisation and allowing investors greater ease in choosing and comparing schemes.

Among the SEBI’s many rulings, one stood out. It made the categorisation of schemes into large-cap, mid-cap and small-cap stock schemes mandatory. This created a specific category for each scheme, which limited the exposure that each scheme had to other stock types. For example, large-cap stock schemes, which involve the shares of the top 100 companies by market capitalisation, had to be comprised of at least 80% large-cap stocks. Midcap schemes, which comprise the next 150 companies by market cap, had to be overwhelmingly weighted with stocks of mid-cap companies and so on.

Fast forward to mid-2018, and the rules have had an unintended effect. They have led to a significant reduction in inflows to small-cap mutual fund schemes, comprising the shares of all other companies outside the top 250. Hence, the rules have shifted the power balance in favour of large companies.

According to data from Prabhudas Lilladher, a brokerage house, small-cap stock schemes recorded a net outflow of ₹220 million between January and June 2018, compared to a net inflow of ₹56.5 billion in the same period of 2017. Meanwhile, large-cap and mid-cap schemes recorded a net inflow of ₹219 billion and ₹145 billion in the first six months of 2018.

Why the focus on large and mid-caps?

It all stems from an investor aversion to risk. 2018 represents a markedly different year from 2017, which was characterised by a booming stock market, an influx of cheap money and high investor optimism.

However, this year, domestic markets have suffered amid concerns of a trade war between the US and China as well as rising oil prices, a falling rupee and widening fiscal deficit. Hence, investors have sought to play it safe by redirecting their investments into larger companies. Small-cap stocks are considered to be more volatile and risky in these kinds of market conditions.

The general rule of thumb is that larger companies are safer and better-capitalised to manage risk than smaller ones. Small-cap stocks might come with higher returns but that’s offset by higher risk. And yes, India’s markets have had a bull run as of late, but this has not extended to small-cap stocks. The Bombay Stock Exchange’s Small-Cap Index is down nearly 12% since the start of the year.

If global market conditions pick up, and mutual fund houses start promoting small-cap schemes, there could be a resurgence in inflows to small-cap companies. The SEBI should keep an eye on the situation, and if necessary, reduce weightage and product restrictions for mutual fund schemes in the interest of diversification.