Why are Mutual Fund houses limiting one-time investments in their smallcap fund?

The recent upsurge in market prices of small-cap stocks has led to significant increases, resulting in valuations exceeding the fair value of the underlying businesses. Consequently, assets under management (AUM) have experienced significant growth. In response to this trend, certain mutual fund houses have taken proactive measures to restrict lump sum or one-time investments, aiming to safeguard investor interests. Recognising the importance of investor protection, the Securities and Exchange Board of India (SEBI) has articulated its concerns and urged mutual funds' asset management companies (AMCs) to adopt preemptive measures to ensure investor protection and market stability.

On why Mutual Fund houses are limiting lump sum investments in their smallcap fund, Gurmeet Singh Chawla, Director, Master Capital Services Ltd. said, “In such a scenario high volatility, limited free float, and events like elections add to the risk factors and the fund manager prefers to restrict investing larger amounts in the form of lump sums while continuing with the systematic investment and systematic transfer plan.”

“The root cause of this concern is high valuation of small-cap stocks and large inflow in small-cap mutual funds. The Nifty SmallCap 100 index has already given more than 70% return in 1 year, and we have seen the valuation of some stocks grow to 3-4 times in 1 year only. Now small-cap valuation has come at a dangerously high level,” said Ravi Singhal, CEO, of GCL Broking

Market regulator Sebi has directed mutual funds to conduct internal stress tests focusing on small-cap stocks. This initiative aims to ensure that sufficient liquidity is available to accommodate significant outflows in the event of a market downturn. Typically, small-cap stocks exhibit low levels of free float market shares. Consequently, any substantial outflow can elevate the impact cost, potentially resulting in losses for investors.

“Both the small-cap and mid-cap segments are in an overbought zone with high euphoria around them. Fund managers are finding fewer reasonable opportunities to invest in. At the same time, the AUM of these schemes has increased heavily and fund managers are finding it difficult to invest in reasonably valued stocks. As a result, restricting fresh inflow is a prudent choice if they are not finding enough opportunities to invest into,” said Mukesh Kochar, national head of wealth, AUM Capital.

Kotak Mahindra Asset Management Company (AMC) has announced restrictions on lump sum investments in its small-cap funds, effective from March 4, 2024. Similarly, Nippon India Life Asset Management declared last year that it would no longer accept lump sum investments into the Nippon India Small Cap Fund. Additionally, Tata Mutual Fund announced in July last year that it would cease accepting lump sum investments and switch-in investments in Tata Small Cap Fund.

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