Why Sebi needs to redefine the scope of large-cap and mid-cap mutual funds

As per the October 2017 definition of market regulator Securities and Exchange Board of India, large-cap funds could invest in companies with a market-cap of over ₹29,000 crore; however, as the market expanded, the minimum threshold has been raised to ₹50,000 crore. Similarly, for mid-cap funds, this number has changed from ₹8,500 -29,000 crore to ₹17,500-50,000 crore.

The average return across the three categories is broadly similar and there is not much to choose from. That said, if a small-cap fund manager were to pick 150 companies from a possible set of 4,800, his chances of beating the average on smart portfolio selection are much better than a large-cap fund (choice limited to 100 companies). At the same time, small-caps (15% of total market cap vis-à-vis 68% for large-caps) would see absorption issues, forcing fund managers to restrict flows into small-cap schemes.

Note that the equity mutual fund (MF) industry has grown from ₹7 trillion in 2017 to ₹18.3 trillion today; given the robustness of this product, investors would continue to see equity MFs as an excellent option for wealth creation. At the same time, the current definition is creating limitation for fund managers and we have seen most new schemes to be around flexicap or focussed or thematic strategy.

Sebi should take a relook at the definition of large and mid-cap companies; if the regulator decides to stick to the market-cap based classification (rather than market-cap rank based), it would be prudent to consider top-150 companies as large-caps (market-cap of more than ₹35,000 crore); companies ranked between 150-400 could be classified as mid-caps (market cap of ₹8,000–35,000 crore] and those above 400 as small-caps. Any reclassification results in forced selling and buying; this was seen in 2018 when large-caps did much better than small-caps as large-cap funds (70% of MF corpus) exited small-caps to buy large-caps. Therefore, for the purpose of reclassification, mutual funds schemes should be given six months to comply.

Although the universe for small-caps is massive, fund managers look at only 150- 200 small-cap stocks. Therefore, the entire MF and institutional market revolves around 400-450 stocks. With reclassification, the number of stocks with institutional interest could expand to 650-700 and hopefully broaden the market. Also, with large-cap funds having more options, large-cap stocks may not see continued inflows; however, since these stocks generate significant interest from foreign institutional investors, any moderation in PE (price to equity) would be made good by foreign buying.

MF reclassification could facilitate continuous addition of stocks after a certain period. We see no downside if the above process is followed; rather, it would help increase access to corporates and improve investor returns.

Ajay Garg is founder and managing director, Equirus.

Updated: 20 Sep 2023, 10:34 PM IST