Why Mutual Fund Houses Stop Fresh Investments

In the last three years, mid- and small-cap mutual fund schemes have given returns of close to 35% to 42% on an average. And they have given average returns of around 15% over the last 10 years, highest in the equity segment. However, in the past few months, valuations of several blue-chip high-quality stocks have hit the roof. In fact, many weaker companies have experienced a sharp correction.

The rally in mid- and small-cap schemes has been so fast and intense that even fund houses are failing to find enough opportunities to invest at this point in time. Recently, DSP BlackRock Micro Cap Fund restricted fresh inflows of over 1 lakh into the scheme. There have been instances where many fund managers have hiked their cash exposure only because of the lack of opportunity in the market.

Another major reason for stopping large flows is that in the last few years the corpus of many mid- and small-cap schemes have risen multiple fold. With assets of around 50,000 crore in such a category, it will be very difficult to deploy any more in it. 

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Due to paucity of high-quality stocks with enough liquidity in the mid-cap space, fund managers of large mid-cap funds may even be forced to invest a part of their portfolio in large-cap stocks, thus reducing the potential return from it. There are many instances of fund managers not being able to book profits in particular stocks for weeks and months due to lack of liquidity in those stocks.

The Indian mutual fund industry is well aware of the fact that smaller funds are easier to manage. Even some large-cap funds like HDFC Top 200 which has grown in size have failed to live up to expectations. This is why fund houses launch close-ended funds as this exercise circumvents the size problem. 

But such measures from fund houses will not solve investors problems,especially if the small scheme they had invested in a few years back has become very large in the current market run-up. One cannot continue to blindly put money in such schemes as there will be times when performance will be impacted. It is always better to invest in funds that are smaller in size with a positive history of performance.

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In this article I have explained why mutual fund houses stop fresh inflows into funds and its impact on the performance of such funds.

When Do Fund Houses Stop Fresh Flows And How Does Additional Inflow Impact The Performance

Inflows into equity or debt schemes is the dream of any fund house or fund manager. With a surge in assets – fund houses can earn income through management fees through expense ratio, which is anywhere between 1.5% and 3%.

But what happens if a fund house plans to stop inflow into its equity scheme for a temporary period and how does it impact investors and the scheme’s performance?

Few years back Franklin Templeton India Prima Fund was one of the first funds to suspend fresh sale of units in January 2006 – when there was an overall euphoria in the bull market. A few months later, Reliance Growth Fund, a mid-cap fund with assets of over 2,400 crore in April ’06 also restricted inflows into its scheme.

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But restrictions and suspension of fresh units are only limited to big-ticket investors (lump-sum investments of `1 lakh and above). Investors who continue to invest through systematic investment plans (SIPs) can, however, continue to do their investments. With rising equity markets and stock opportunities, the mutual fund industry continued to focus on ‘assets gathering’.

But in 2008-09, financial crises hit the global markets, and there was a blood bath on Dalal Street. IDFC Premier Equity, another mid-cap scheme, stopped further subscriptions although investors could invest through SIPs. Later, the fund house decided to open a small window for fresh investments for a few months. This phenomenon continues even today when fund managers feel that the stock markets are overheated.

A scheme typically chooses to stop fresh inflows when there is a perceived lack of investment ideas. Instead, fund managers might choose to sit on the cash till the market opens up for sound investments.

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While maintaining a higher cash position could help the fund outperform when the market is sliding, there is a limit to how much cash a fund can keep (fund houses are mandated to write on offer documents). The fund may not always be in a position to wait it out and avoid investing altogether. 

In such cases, restricting inflows in the scheme is the only way out. In the Indian mutual fund industry as well as the international fund business, another reason for stopping incremental inflows is when the scheme corpus grows too unmanageable for the fund manager. 
This typically happens when the broader market is on an upswing or when the fund is doing exceedingly well, attracting a surge of money from return-hungry investors.

Last year, SBI Small & Midcap Fund stopped inflows because the mutual fund scheme had outlined a capacity constraint of 750 crore in its offer document, implying that it would not absorb additional money beyond the set threshold. 

If we look at all the mentioned schemes, we see that these were typically mid- and small-cap schemes because limited investible basket of stocks, coupled with liquidity concerns around these stocks put the fund manager in a difficult position when faced with continuing inflows. However, for retails investors the best thing is to continue with their SIPs and not stop only because the markets are either expensive or cheap.

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Is More Exposure In Mid- And Small-cap Funds Hazardous?

At the start of calendar year 2013, very few investors were ready to invest in mid- and small-cap schemes. Valuations of several mid- and small-cap stocks were available at huge discounts and many fund houses had launched closed-ended equity schemes. By November-December 13, there was a sharp surge in midand small-cap rally, which has more or less peaked out by now.

But in the last three-and-a-half years, several investors jumped to buy small- and mid-cap schemes as past returns in these schemes made them irresistible. In the year 2014, several small-cap schemes were giving one-year returns of more than 100% and the typical Indian psyche of investing in a surging market was on full display yet again.

Now, the rally seems to have lost steam with a number of mid- and small-cap stocks crashing by 10% to 20%. A few have even touched an all-time high with unreasonable valuations. Therefore, it is very important at this juncture to analyze the performance of investments in mid- and small-cap focused mutual funds and understand how the future looks like for them, going forward.

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The equity markets have risen in the past few months largely due to the passage of the Goods and Service Tax (GST) bill and positive monsoon. But with uncertainty in Europe and China and election in the US, it is likely that the Indian equity markets might remain volatile.

But as we know small- and mid-cap stocks and schemes are more volatile than pure large-cap or broader markets, it is important for investors to not aggressively invest only in mid- and small-cap schemes as it was the case in the last few months. In the last one year, midcap index and small-cap index have given returns of 16% and 8%, respectively.

Mid- and small-cap mutual funds outperform rest of the market when the economic outlook is positive as we saw during the 2003-08 bull market. At such a time if the demand for risky assets such as equities is not mitigated, smal-cap stocks see sharp rallies (as was visible in selective stocks) as investors try to make quick bucks. Such euphoria often happens towards the end of a bull market.

On the other hand, when the markets are nearing the bottom and small caps start looking cheap, chances are greater that they become even cheaper as panic selling takes them to new lows.
Many times small- and mid-cap stocks may remain completely out of flavour if markets fail to stabilize thereafter much like the pre-2013 period of nearly four years. At this juncture, when the extended bull rally in Indian equities looks difficult, it would be wise to stay with large- and multi-cap funds.

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In A Nutshell

As said above in the article small-caps and mid-cap mutual funds outperform the rest of the market when the economic outlook is robust and large caps look expensive. But on the other hand, large caps can be relatively stable as against mid- and small-caps. So they would not go up much or fall if fundamentals justify their valuations compared with their mid- and small-cap peers. 

It is time to revisit your portfolio and reassess your asset allocation. Due to the current market rally, if your equity exposure has increased to a great extent than what you had planned or,it’s time to re-balance the portfolio and have a mix of equity and fixed income portfolio

Similarly, you should redeem your money from schemes that have under-performed in the last few years and look out for other schemes and continue investments through SIPs.

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