Mid-cap and small-cap stocks took a beating on Wednesday, falling almost 2% after the Association of Mutual Funds in India (Amfi) asked mutual fund houses to have a policy that will safeguard investors in mid- and small-cap schemes.

The Amfi advisory came after a nudge from markets regulator Securities and Exchange Board of India (Sebi), said industry players.

According to the Amfi advisory, mutual funds should moderate inflows into these schemes and also rebalance the portfolio. Also, they should ensure that investors are protected from the first-mover advantage of redeeming members.

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“In the context of froth building up in the small and mid-cap segments of the market and the continuing flows in the small and mid-cap schemes of mutual funds, trustees in consultation with Unitholder Protection Committees of AMCs, shall ensure that a policy is put in place to protect the interest of all investors,” the advisory said.

The mid-cap index closed at 39,019.19, down 724 points or 1.82%, whereas the small-cap index closed at 44,998.14, down 890 points or 1.94.%

According to Dhirendra Kumar, CEO, Value Research, the markets regulator keeps on sensitising the mutual fund industry on these issues occasionally to ensure that there isn’t over-excitement in the market. “That’s good — it’s part of the regulator’s job – but it’s not advice that fund investors need to act upon urgently. Those who are speculating in smaller stocks are equity traders. However, mutual fund investors are a different lot – they are mostly going through the systematic investment plan (SIP) route. They have all the advantages of cost averaging and diversification that mutual funds provide. I’m sure they’ll be fine.”

However, market players are worried that moderating inflows into schemes would reduce the fresh inflows, thereby limiting the price growth of these stocks. Additionally, there are also fears that fund managers, fearing redemption from investors sitting on profits, may decide to raise cash from the market by selling their holdings. This may lead to a fall in the stock prices.

The market watchdog’s message to the fund houses comes at a time when investors have been aggressive on mid and small-cap funds, while large-cap schemes have not seen significant inflows. That is, in 2023, small-cap funds saw net inflows of `41,035 crore, while mid-cap funds saw net investments of `22,913 crore. On the other hand, large-cap funds witnessed a net selling of `2,968 crore,  according to data from Amfi. Clearly, investors have taken a liking to the riskier schemes compared with safer large caps.

Even in January, small-cap schemes witnessed inflows of `3,257 crore received an inflow of `3,257 crore, mid-cap funds saw an inflow of `2,061 crore, while large-cap funds saw an inflow of approximately `1,287.05 crore.

No wonder, the assets under management (AUM) of these schemes have swelled significantly. In fact, they are closing in fast on AUMs of large-cap funds. For instance, the AUM of large-cap funds stood at `2.96 trillion in December-end, whereas the AUM of mid-cap and small-cap funds stood at `2.82 trillion and `2.34 trillion, respectively.

Fund houses like Kotak Mutual Fund have already said that they will not accept fresh money in their small-cap scheme. In a notification dated February 26, Kotak Mahindra Asset Management Company said that it has temporarily limited the subscription of units, including switch-ins, into Kotak Small Cap Fund with effect from March 4, 2024.

Fresh lump sum investments, including additional investments or switch-ins, will be capped at `2 lakh per PAN (first holder or guardian) per month.

SIPs and Systematic Transfer Plan registrations will continue with a monthly limit of `25,000 per PAN for various frequencies, the fund house said.