Sebi Chief Warns Of Potential Bubble In Small And Mid-cap Stocks; What Should Investors Do?

Stock market regulator, Securities and Exchange Board of India's (Sebi), chairperson Madhabi Puri Buch on March 11 2024 raised concerns about over valuations of small and mid-cap stocks, indicating possible market manipulation and the risk of a market bubble. "There are pockets of froth in the small and mid-cap space in the equity markets that have the potential to become a bubble and burst affecting investors, she said. On the overvaluation of small- and mid-cap stocks, Buch said Sebi's data analysis shows in some cases the “valuation parameters are off the charts and not supported by fundamentals and appearing to be a case of irrational exuberance.”

She even said Sebi will review its rule that mandates small-cap and mid-cap mutual funds to invest a minimum of 65 per cent of their assets in small or mid-cap stocks if fund managers feel such a move will help them manage the risk in a better way.

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Background

After small-cap mutual fund schemes attracted over Rs 41,000 crore in 2023 double the amount in the previous year, Sebi took it as a sign of bubble and asked mutual fund houses to put in place a framework to safeguard the interest of investors. Earlier this month Sebi had mandated that all asset management companies had to conduct stress tests on small- and mid-cap funds and find the time required to sell a quarter and a half of its holdings if the market crashes and there is a rush to redeem. This would indicate how fast investors will be able to liquidate their holdings during a market collapse.

What Do Fund Managers Say?

Despite Sebi's red flags, few portfolio managers and mutual fund house managers have a mixed view, where some feel there are no alarming signs of redemptions in small-midcap space.

According to PTI news agency, some managers have stated that investors are likely to keep investing in small and mid-cap funds, as they have the potential to provide high returns. Despite the warning, these managers believe that investors will continue to follow this trend, as historically inflows have chased returns. They feel the high GDP growth, cash balance with mutual funds and SIP money flowing in are enough to prevent deep corrections in the market.

However, Kaustubh Belapurkar, Director – Manager Research, Morningstar Investment Research India said investors looking to invest in small and mid-cap funds should not expect the recent high return trajectory to continue, and be ready to face interim volatility.

What Do RIAs Say?

Avinash Luthria, Sebi Registered Investment Advisor (RIA) at Fiduciaries said, "If more than 50 per cent of your total portfolio including Provident fund or Fixed deposit is in equity, you might be taking on too much risk. Additionally, if you invest one-third of your equity portfolio (i.e. more than their free-float weight in the stock market), is in mid and small-caps, then it is excessively risky. You should fix those two errors in your portfolio at the earliest."

Free float weight of mid and small-caps in the stock market refers to the percentage representation of publicly available mid and small-cap stocks in the overall stock market. If you allocate more than 33 per cent of your equity in mid and small caps, exceeding the free-float weight representation, it means you are overweighing them in your portfolio vis-a-vis their representation in the broader market.

Ajay Pruthi, another Sebi RIA and founder of PLNR stresses the point of diversification to reduce risks. He said, "Investors should first identify their need for liquidity in the next few years and then allocate their savings into a mix of debt and equity based on their risk appetite for long-term goals."

"Also, they should avoid putting a large part of their savings into equity because if immediately after that their equity investments go down drastically then they might have to hold on to their position for a long time so they should spread out the investment over a period of time to avoid such risk," Pruthi reminded.