SEBI asks mutual funds to limit small cap, midcap fund inflows: Market got spooked after the curb

India’s market regulator, SEBI, has asked money managers to restrict investments in small- and mid-cap stock mutual funds and reduce commissions. The move aims to curb surging inflows into these funds and address the extraordinary exuberance in small- and mid-cap stocks. SEBI wants small- and mid-cap funds to make additional risk disclosures to their investors.

According to news reports, the Securities and Exchange Board of India (SEBI) communicated this to the money managers in a meeting earlier this month. The regulator did not specify the quantum of flows it wants to be restricted. The market regulator’s communication to money managers about one-off investments is not an official order. The industry has in the past almost always complied with messages from SEBI.

Small cap and midcap indices fell after capital markets regulator SEBI advised mutual funds to protect investor interest by limiting flows, rebalancing portfolios, and other measures.

It is learned that the Association of Mutual Funds in India (AMFI), an industry lobby body, has in a letter asked fund houses to protect investors “including but not limited to moderating inflows”. Among the key things mutual funds have been told to do are to moderate inflows, rebalance their portfolios, and ensure that investors who redeemed early did not put the remaining investors at a disadvantage at any point.

Moderating inflows could mean restrictions on fresh money coming into midcap and small-cap schemes. In some way, it was the continuous flow of funds into these schemes that was driving stock prices higher. For example, in the year 2023, midcap mutual fund schemes got inflows of Rs 22,913 crore, and smallcap schemes got Rs 41,035 crore. On the other hand, large-cap schemes saw an outflow of Rs 2,968 crore.

While more and more investors put money into these schemes, prices move up and in turn, attract more investors. This creates a self-fulfilling effect because mutual funds have to deploy the money in the market, resulting in a stock price rise and an increase in the NAV of the scheme attracting more investments in the scheme. This has a catastrophic effect when the reverse cycle starts. When prices fall sharply, some investors may panic and rush to redeem. When the funds sell stocks to return money to investors, stock prices fall, causing the net asset value of schemes to decline. This could lead to more selling by existing investors.