SEBI multi-cap reclassification circular (September 2020)
The SEBI multi-cap reclassification circular of 11 September 2020, formally Circular No. SEBI/HO/IMD/DF3/CIR/P/2020/185, mandated that all mutual fund schemes categorised as “multi-cap funds” must invest a minimum of 25 percent each in large-cap, mid-cap, and small-cap stocks, with no more than 25 percent in any category left to fund manager discretion. Before this circular, multi-cap funds had operated with complete investment flexibility across market capitalisations, and in practice most had accumulated predominantly large-cap heavy portfolios with minimal mid and small-cap allocations despite their multi-cap category designation. The circular required these funds to substantially increase their small-cap and mid-cap allocations, triggering one of the largest mandatory portfolio rebalancing events in the history of the Indian mutual fund industry. It also prompted the Securities and Exchange Board of India to create a new “flexi-cap fund” category to preserve the option of genuinely flexible equity mandates without the new minimum allocation requirements.
Background: SEBI’s scheme categorisation circular of 2017
The multi-cap reclassification of 2020 was a follow-on action to SEBI’s comprehensive scheme categorisation and rationalisation circular of October 2017 (Circular No. SEBI/HO/IMD/DF3/CIR/P/2017/114), which had introduced standardised scheme categories across the Indian mutual fund industry to eliminate the proliferation of similar schemes under different names.
The 2017 circular defined multi-cap equity funds as schemes investing in equity and equity-related instruments across large-cap, mid-cap, and small-cap stocks, with a minimum 65 percent equity allocation and no specific floor or ceiling on allocations across the three market capitalisation bands. The circular intended “multi-cap” to mean genuinely diversified across all market cap segments, but the definition allowed fund managers complete discretion over the intra-equity allocation.
In the years following the 2017 circular, SEBI conducted a review of multi-cap fund portfolios and found that the overwhelming majority of multi-cap funds had portfolios heavily skewed toward large-cap stocks, in many cases, 70–80 percent large-cap, 10–20 percent mid-cap, and only 5–10 percent small-cap. This was not consistent with the spirit of “multi-cap”, a category designed to offer investors genuine exposure across market segments. SEBI concluded that investors choosing multi-cap funds on the expectation of diversified market-cap exposure were, in effect, receiving predominantly large-cap portfolios that differed little from explicitly large-cap funds.
The September 2020 circular
SEBI issued Circular No. SEBI/HO/IMD/DF3/CIR/P/2020/185 on 11 September 2020, announcing that multi-cap fund schemes must, with effect from January 2021:
- Invest a minimum of 25 percent of total assets in large-cap stocks (as defined by SEBI’s standardised market capitalisation list).
- Invest a minimum of 25 percent of total assets in mid-cap stocks.
- Invest a minimum of 25 percent of total assets in small-cap stocks.
- The remaining 25 percent could be invested at the fund manager’s discretion across any or all of the three categories.
The circular gave existing multi-cap schemes a compliance deadline of January 2021 to achieve the new minimum allocations.
Scale of required rebalancing
The market impact of the circular was immediately apparent to market analysts. The combined AUM of multi-cap funds as of September 2020 was approximately Rs 1.46 lakh crore. Based on typical portfolio compositions, large-cap dominant with small and mid-cap underweighted relative to the new 25 percent floor, the total amount of large-cap stocks that needed to be sold and mid-cap and small-cap stocks that needed to be purchased was estimated by brokers at Rs 25,000–35,000 crore of small-cap purchases and Rs 20,000–30,000 crore of mid-cap purchases required, with commensurate large-cap selling.
Such a large mandatory reallocation had significant price implications:
- Small-cap and mid-cap stocks were expected to rally sharply on the anticipated incremental demand from multi-cap fund rebalancing.
- Large-cap stocks faced the prospect of selling pressure as multi-cap funds reduced overweight positions.
- Liquidity in small-cap stocks, which was relatively thin, meant that even modest additional institutional demand could produce outsized price moves.
The market’s anticipation of this rebalancing contributed to a sharp outperformance of the mid-cap and small-cap indices versus the large-cap indices in the weeks following the September 2020 circular, before the implementation deadline.
Creation of the flexi-cap category
Acknowledging that the mandatory 25-25-25 allocation structure constrained investment flexibility in a manner that some fund managers and investors valued, SEBI simultaneously announced (in November 2020) the creation of a new scheme category: flexi-cap fund. Flexi-cap funds were defined as equity schemes investing across large-cap, mid-cap, and small-cap stocks with a minimum 65 percent equity allocation, but with no minimum requirements within any market capitalisation segment, the investment flexibility that multi-cap funds had previously enjoyed.
AMCs running existing multi-cap funds that did not wish to rebalance to the new 25-25-25 minimum structure were given the option of reclassifying their schemes as flexi-cap funds instead of restructuring portfolios. This provided a practical exit from the compliance requirement for funds that had large-cap-dominated portfolios and did not wish to force a rebalancing event on their investors.
A large number of AMCs chose to reclassify their existing multi-cap schemes as flexi-cap schemes. Within months of the circular, flexi-cap had emerged as one of the largest scheme categories in the equity mutual fund universe by AUM, effectively inheriting much of the multi-cap category’s prior asset base. The genuinely restructured multi-cap category became a smaller but distinct category with verifiably diversified market-cap exposures.
Investor and industry impact
For investors, the multi-cap reclassification had mixed effects:
- Investors who remained in restructured multi-cap funds gained genuine small-cap and mid-cap diversification they had not previously had. In the subsequent bull market of 2020–2021, which saw mid-cap and small-cap indices outperform the Nifty 50 significantly, this was beneficial.
- Investors in schemes that converted to flexi-cap effectively retained the status quo and experienced no portfolio disruption.
- The mandatory demand injection into small-cap stocks produced a liquidity benefit that temporarily aided the small-cap market, though it also raised questions about market price distortion from regulatory-mandated portfolio allocation rather than fundamental valuation.
For the mutual fund industry, the circular demonstrated SEBI’s willingness to intervene prescriptively in portfolio construction rules when it concluded that existing scheme category definitions were being implemented in a manner inconsistent with investor expectations. The episode reinforced SEBI’s role as an active supervisor of product design rather than merely a registration and disclosure regulator.
Key dates
| Date | Event |
|---|---|
| October 2017 | SEBI scheme categorisation circular: multi-cap category defined without minimum allocation floors |
| 11 September 2020 | SEBI circular: 25-25-25 minimum allocation mandate for multi-cap funds |
| November 2020 | SEBI introduces flexi-cap as a new scheme category |
| January 2021 | Compliance deadline for multi-cap scheme restructuring |