Mumbai: The Securities and Exchange Board of India (Sebi) has asked trustees of mutual funds to establish a framework aimed at safeguarding interests of investors in small and midcap schemes. The heightened regulatory scrutiny comes in the wake of concerns that these share segments are overheated, while investor flows into these schemes continue unabated.

The regulator has, in a communication sent to Association of Mutual Funds in India (AMFI) on Tuesday evening, asked fund houses to list the steps they are taking to protect investors in such schemes in next 21 days, said two people in the know. “In the context of froth building up in the small and mid-cap segment and the continuing flow in small and midcap schemes, trustees in consultation with unitholder protection committees of AMCs shall ensure that a policy is put in place to protect interest of all investors,” Sebi said in the letter, which ET has reviewed.

Some MF Houses Have Already Imposed Curbs
Sebi said the investor protection policy entails two aspects. One is mutual funds and fund managers stating the “appropriate and proactive” measures taken to protect investors, in addition to curbing inflows and investment portfolio rebalancing. Secondly, fund houses must detail the steps taken to ensure that investors are “protected from the first-mover advantage of redeeming investors”.

Sebi’s concerns about the wellbeing of investors in small- and mid-cap schemes stem from the persistent trend of money pouring into smaller illiquid stocks. Though these stocks have been outperformers by a big margin in the past year, there has been growing unease on Dalal Street that their rise might have been excessive. While smaller shares tend to witness sharp spurts in bull markets, the fall tends to be brutal when sentiment turns sour. The regulator is anxious that in the event of a selloff, there could be an investor stampede for redemptions from mid-cap and small-cap schemes, putting liquidity pressure on mutual funds.

Some asset managers such as SBI Mutual, Kotak Mutual Fund, Nippon India and Tata Mutual have already imposed subscription restrictions on small-cap schemes such as investment limits per individual with red-hot share valuations making it challenging for fund managers to handle continuous flows.

The assets under management (AUM) of small cap schemes hit a record ₹2.48 lakh crore in January 2024. It was at almost 83% of the AUM of the large cap scheme category of ₹2.99 lakh crore in January, against 44% in August 2021, according to data from Samco Mutual Fund.

Similarly, assets of midcap funds rose to ₹2.9 lakh crore. They stood at 97% of the large-cap scheme AUM as against 69% earlier.

In the past 12 months, small cap funds have seen net inflows of ₹42,037 crore while midcap funds have seen inflows of ₹23,346 crore. Cumulatively, this accounts for 38% of the total of ₹1.7 lakh crore flows into equity mutual fund schemes in this period.

The flows have been on account of the superior performance of mid- and small-cap stocks in this period.

In the last three months, the S&P BSE Small Cap TRI (Total Returns Index) and S&P BSE Midcap TRI rose 16.9% and 16.11%, while in the past year the rise was 70.64% and 59.08%, respectively. In the same period, the Nifty rose 15.59% and 29.06%.

“(A) few stocks in the small and mid-cap segment have multiplied, and strong momentum is taking them beyond the fair value of businesses,” said Kotak Mutual Fund’s letter to investors earlier this week, communicating its decision to restrict flows into its small-cap scheme from March 4. “Retail investors’ ownership of the small-cap segment has also become sizable, crossing even institutional ownership in many stocks.”