SEBI’s (Securities Exchange Board of India’s) missive to the mutual fund industry warning of froth building up in small-cap stocks has come not a day too soon. Euphoria in this segment has been all too evident with small-cap indices delivering returns of 60-70 per cent in the past year compared to a 26 per cent gain in the Nifty 50. The breathless rally has bid up the price-earnings multiple of the Nifty Smallcap 250 Index to 29 times, a stiff premium to the Nifty 50’s 23 times. Enthusiastic retail buying of penny stocks is a sign of a bubble in the making. Small-cap funds have garnered a lion’s share of recent inflows into mutual funds, with their managed assets shooting up by 90 per cent in one year.

Such large flows create significant challenges for small-cap funds. With a flood of money chasing a limited investible universe of 500 to 600 stocks, valuations of good quality small-caps have shot through the roof. Popular small-cap funds have also become unwieldy to manage. Given the lack of depth in this segment, any purchase or sale of shares by larger funds now carries significant impact costs, moving stock prices by 20 per cent or more. With inflows forcing funds to remain in buy mode, net asset values (NAVs) have spiralled higher. Should a market correction unfold, there is a risk that this chain of events will play out in reverse with buying interest in small-cap funds evaporating, liquidity vanishing and stock prices tanking, taking down NAVs. Some asset management companies (AMCs), having burnt their fingers in past market cycles, seem to be aware of these risks and have implemented measures such as barring lumpsum investments, allowing only systematic investments and fully using the 35 per cent leeway to hold large-cap stocks.

Given this scenario, when asking trustees, AMCs and fund managers to take “appropriate and proactive measures” to protect investors, SEBI could have been more specific in what it thinks they should do. Some of the options that AMCs could look at, though it will work against their commercial interests, will be to completely gate inflows, delay deployment, hold higher cash and create promotional campaigns that warn investors of the risks in small-cap funds.

While this appears feasible at least, SEBI’s diktat that funds should also take steps to ensure that “investors are protected from the first mover advantage of redeeming investors”, seems to be a tough ask. In the open-end structure, AMCs are bound to honour redemption requests at the prevailing NAV. Should markets correct and NAVs of small-cap funds decline, investors who exit first will enjoy an undoubted advantage over those who exit later. AMCs can at the most levy heavier exit loads on redemptions to discourage exits. But they must not deny investors exit during market distress, as was done during the Franklin Templeton crisis. This will irredeemably harm investor confidence in the mutual fund industry.