The Securities and Exchange Board of India (Sebi) has asked fund houses operating smallcap funds with a large corpus to share data on their holdings in the total free float of smallcap stocks, according to sources.
This is part of the stress tests that the regulator wants fund houses to undertake amid a surge in inflows into smallcap schemes and growing concerns about valuations.
Free float refers to the quantum of freely available shares for trading on the stock market.
Typically, shares held by public investors and those not under any lock-in are considered free float.
Large mutual fund (MF) ownership in a low-free-float stock can create liquidity issues, especially during periods of market downturn.
“Sebi wants to determine how much illiquidity there is in the market.
"If all the funds have holdings in a limited set of companies and there is no free float, then it could be an issue.
"This is an extension of the stress testing done by the regulator. They want to find out what percentage of the total free float is owned by fund houses,” said a senior MF executive.
At an event last month, Sebi chairperson Madhabi Puri Buch said that the regulator was actively discussing stress tests of smallcap and midcap schemes with the MF industry.
She also said that Sebi had reviewed reports from the first round of tests, but they left her wanting more data.
“The idea is to see how things will look if a market drawdown happens.
"They are interested in knowing about the free float owned by MFs and how many days it will take to liquidate the holdings if a major correction happens,” said another executive.
Smallcap and midcap funds have come under Sebi’s radar as investors continue to pour large sums of money into these funds, despite elevated valuations.
In the calendar year 2023, smallcap and midcap schemes accounted for 40 per cent of the total net inflows into active equity schemes, receiving Rs 64,000 crore of total inflows of Rs 1.6 trillion.
In another sign that the regulator might be concerned about overheating in the smallcap space, Sebi had recently written to fund houses asking if they have placed any restrictions on the amount investors can put into their smallcap funds.
In 2023-24, the National Stock Exchange Nifty Smallcap 100 is up nearly 80 per cent.
As a result, the 12-month forward price-to-earnings ratio of the index has surged to 21.7.
The 10-year average is 16.5, according to Bloomberg data.
Apart from the risk of sharper corrections compared to largecap stocks, smallcap shares also face liquidity risks as the volumes traded tend to be relatively thin.
Given that MFs have to pay back investors within a couple of days of notice, risks on the liquidity side can become a challenge for MFs to meet redemptions, especially during periods of distress.
During stress testing, MFs evaluate if they will be able to meet large redemption pressures, considering the recent liquidity in the stocks that they hold.
To mitigate risk, some fund houses have already decided to limit inflows into their schemes.
Kotak MF announced on Monday that it is capping lump sum investments at Rs 2 lakh and systematic investment plan investments at Rs 25,000 per month.
SBI MF, Tata MF, and Nippon MF also have restrictions in place.
MF executives believe that their schemes are prepared for market downturns as a significant part of the corpus, around 20 per cent to 30 per cent, is in cash and largecap stocks.
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