CY 2018 : Intriguing!
An analysis indicates that Small Caps bore the brunt almost entirely due to the Sebi circular on mutual fund reclassifications while for Mid Caps, the subsequent changes to Nifty Mid Cap Index apart from the Sebi circular caused a vast rotation between stocks. The selling pressure may have spread across other unimpacted categories as well as counter specific sales exacerbated the negative sentiment. Money flows continued into Mid Caps while Small Caps were abandoned and within Mid Caps, the index exclusions were sold into while the new incoming ones/ ones in status quo were bought into substantially. In effect, the vast divergence between indices and within indices, stocks, is seen to be a direct and unquestionable result of the Sebi reclassification norms.

KEY FINDINGS – 1

The Sebi circular started the chaos...

September 2017-January 2018 : The period prior to correction

Small Cap stocks witnessed a net inflow of Rs 5,650 crore by mutual funds. Large Caps and Mid Caps reported a net buying of Rs 8,170 crore and Rs 14,320 crore respectively by mutual funds.

January 2018-June 2018 : The correction period

Small Cap stocks witnessed a net selling of Rs 22 crore (January-June) by mutual funds. About Rs 280 crore was sold in April 2018, while Rs 140 crore was sold even in June 2018. In the same period, Rs 21,900 crore worth of Large Cap stocks were bought, while Mid Cap stocks as per changed definition reported a net buying of Rs 14,500 crore.

Despite the strong inflows in the January-June 2018 period

Small Cap stocks didn’t see any buying from these inflows on net basis. Mid Cap stocks saw buying yet the Mid Cap indices fell.

The double whammy? 35% of AUM impacted by churn…

Major capitalisation rotation was seen in the (new) Large & Mid Cap category, Mid Caps (shunned Smaller Caps as forced to identify Mid caps) and focus funds (limited to 30 stocks and they ended up with preference to Large caps) – impacting roughly 35 per cent AUM of equity mutual funds, totaling

Rs 5.47 lakh crore. Each of these seems directly correlated to the Sebi circular – especially for the Small Cap exodus which is common across the board. Mid Caps gained especially via two specific categories – Large & Mid Cap and Mid Cap fund category itself – which both caused buying due to re-classification. So, while the above explains the complete abandonment of Small Caps and shows inflows into Mid Caps, then why did the Mid Cap index suffer?

The Sebi circular: Uniform definition for Large Cap, Mid Cap and Small Cap stocks

On october 6, 2017, Sebi issued a circular for the categorisation & rationalisation of mutual fund schemes which were implemented between January to June 2018.

The circular sought to create uniformity in the mutual fund industry by:

*Setting clear definitions of Large Cap, Mid Cap and Small Cap stocks.

*Creating specific categories of mutual fund schemes, where only one scheme is allowed per category.

As per value research, roughly 30 equity schemes changed their categorisation post Sebi’s classification.

The circular defined Large Cap, Mid cap and Small Cap stocks as below:

*Large Cap: 1st-100th company in terms of full market capitalisation /Mid Cap: 101st-250th company/ Small Cap: 250th company and below.

Before Sebi’s circular mutual funds had a free-hand in deciding the definition of Large Cap or Mid Cap stocks:

*Some schemes defined large caps as all companies with a market capitalisation equal to or greater than the company with the least market capitalisation in the CNX Nifty Index (DWS Large Cap fund).

Some funds defined Mid Caps as those that are either:

*Constituent of Nifty Free Float Mid Cap 100 Index (benchmark) or companies that have a market capitalisation between the highest and the lowest market capitalisation of Nifty Free Float Mid Cap 100 Index (IDBI Mid Cap Fund).

The Sebi circular: Timelines for mutual funds

This circular applied to all open-ended funds in existence or those that were planned to be launched in the period. Open-ended equity funds accounted for Rs 67,677 crore of net inflows between January -June 2018 and hence the significance of this circular.

Subject to Sebi’s approval, mutual funds had to carry out the necessary changes in all respects within a maximum period of 3 months from the date of such observation. From mid-February 2018 till the beginning of June 2018, mutual fund houses began effecting changes to their scheme classification and portfolio allocation to meet Sebi guidelines.

The NSE index replacement circular pinning down the stocks!

On February 21, 2018, NSE issued a circular on index replacement that was to become effective from April 2, 2018. As a result, in the Nifty Mid Cap 100 index, 46 stocks were replaced effective from April 2, 2018. Out of these 46 stocks excluded, 35 stocks were reclassified as Large Caps (19) and Small Caps (16), while the remaining 11 stocks from the 46, though meeting the definition of Mid Caps as per Sebi, were removed from the index. These 11 stocks, did not qualify with NSE’s selection criteria for the index.

KEY FINDINGS – 2

The NSE circular put the last nail!

Calculations show inflows of about Rs 14,500 crore into Mid Caps stocks during the period as well as a preference to Mid Caps. Then why did the Mid Cap index correct by about 14 per cent over the January 2018– June 2018 period? The NSE circular on index replacement (effective April 2, 2018) meant that 46 stocks were replaced effective from April 2, 2018, in the Nifty Mid Cap 100 index. Of the 46 stocks that were excluded from the Mid Cap index, 35 stocks were categorised as Large Caps/Small Caps by Sebi/Amfi. Between January 31-June30, there was a net outflow to the tune of Rs 1,141 crore from these 35 stocks, accounting for almost 45 per cent Mid Cap index as weightage on January 31, 2018.  There was a net buying of Rs 1,043 crore in the remaining 11 stocks that remained in the Mid Cap space as defined by Sebi, but not in the index, mainly because net inflows continued. There does therefore seem to be causation as mutual funds must have exited stocks on the Mid Cap index which weren’t Mid Caps any more.
Mutual Funds Exited Stocks Excluded From the Nifty Mid Cap 100 Index

BETWEEN JANUARY 31-JUNE30,

*Net outflow to the tune of Rs 1,141 crore from these 35 stocks.These 35 stocks had a total weightage of 45% in the Nifty Mid Cap index.

*At the same time, Rs 4000 odd Crore came into stocks that joined the index

*Net Inflow of Rs 6000 crore odd in the stocks that didn’t change due to reclassification .

The Polarisation: Some Shunned, Some Preferred !
The table below summarises the number of counters impacted by reduction or accumulation in quantity during Q1 FY2019.

Large Cap and Mid Cap stocks both show that MFs entered more counters than they exited, while in the Small Cap category, there seems to have been a complete shift
This extreme behaviour seems a direct link to the SEBI/NSE circulars and not just market conditions