Earlier this month, Sebi announced the introduction of a new category of equity mutual funds. This new category, called “flexi-cap fund”, aims to create funds that allocate in large, mid, and small-cap securities flexibly, without the restrictions present in the existing categories such as multi-cap funds. But how is this new category different from the multi-cap category which had pretty much the same objective — to allow investors access quality stock picks without being bound to market capitalisation? Let’s look at the key takeaways from this notification for investors.

Market cap classification

Let’s first understand the matter of market capitalisation — the value of a company being traded on the stock market. For example, a company with one lakh shares worth Rs 100 each would have a market capitalisation of Rs 1 crore.

Sebi classifies the Top 100 companies by market capitalisation as large-cap firms. Companies ranked 101 to 250 are classified as mid-caps, and those ranked 251 onwards are classified as small-caps.

Large companies are seen to be safe, stable and capable of providing steady returns whereas smaller companies are considered riskier, volatile but capable of providing explosive returns.

Equity mutual funds are created keeping in mind the underlying stock’s market cap. For example, a large-cap fund must invest at least 80 per cent of its portfolio in the securities of large-cap companies. There now exist several equity fund categories tailoring to all sorts of risk appetites — large-cap funds, mid-cap funds, small-cap funds-and categories such as flexi-caps that straddle these divides.

Nuts & bolts of flexi-cap

Sebi announced that the new category will require its funds to invest a minimum of 65 per cent of the portfolio in equity securities.

Additionally, the diversification across large, mid and small-cap stocks will be open-ended. It means that the manager of such a fund is free to invest in a stock regardless of its market capitalisation and in the ratio he considers appropriate for his scheme.

In September, Sebi had made alterations to the multi-cap fund category rules, asking fund houses to invest a minimum of 75 per cent in equity, with a minimum of 25 per cent each in large, mid and small-cap stocks. Before September, multi-cap funds had to invest only a minimum of 65 per cent in equity without the restrictions on diversification by market capitalisation. In essence, the flexi-cap category is a return to the earlier iteration of the multi-cap category.

Why was this necessary?

In September, Sebi pointed out that multi-cap funds were operating as large-cap funds with limited exposure to small companies. They lacked the necessary diversification to be called multi-cap — or in Sebi’s words, they were not “true to label” as the scheme’s portfolio didn’t reflect in the scheme’s name.

Several of these funds had 70-90 per cent exposure to large-cap companies. The new rules would have forced much greater diversification in these funds, forcing them to buy more small companies, rebalance their portfolios or even merge with other schemes to ensure compliance.

However, there was a pushback from various quarters and the broad sentiment was that fund managers must be free to pick stocks in the ratio they consider appropriate for their scheme’s investors. So, for example, fund managers may lower their exposure to small-caps in an overpriced market heading towards a correction, or even increase such exposure if they spot opportunities to provide higher returns for investors.

The bottomline: let the fund managers alone decide. Multi-cap schemes are extremely popular with AUMs of nearly Rs 1.5 trillion, and, therefore, in order to accommodate investors and not cause upheaval in the stock prices of small companies, it was decided to create a new category under which business could go on as usual.

Impact on funds

The new category allows fund managers greater freedom. It also allows investors to choose funds where stocks are being selected on merit without being bound by market cap rules.
Both flexi-cap and multi-cap categories will now co-exist though it is being seen that multi-cap funds have started reclassifying themselves as flexi-cap.

Many multi-cap funds, including Kotak Standard Multicap, the biggest fund in the category with an AUM of Rs 29,807 crore, have announced their decision to become flexi-cap funds. It remains to be seen if new multi-cap funds are launched following this because their in-built diversification requiring at least 50 per cent allocation towards small companies may continue to attract new investors with high risk appetites.

Impact on investors

Existing funds in the multi-cap category can move to the new category. As this would mean a change in the investment style for the fund, their investors will be allowed to exit them without having to pay an exit load. They will be given 30 days to do so.

A reclassification of a lock-in investment will not attract taxation. However, switching from one scheme to another will be considered a redemption. As a result, capital gains tax will be applicable. That said, investors must also evaluate if flexi-cap investments suit their financial objectives or if they are better off investing in other categories if they desire higher returns and greater diversification.

If you were a multi-cap fund investor, your fund may likely become a flexi-cap, and it would behave the way it had before September. However, if your risk appetite is higher, you may consider funds with higher exposure to small companies. These funds would also include the new-look multi-caps.

The writer is CEO, BankBazaar.com