Flexibility on fund investment limits

S. Vaidya Nathan

THE SECURITIES and Exchange Board of India (SEBI) has to examine seriously the possibility of providing more flexibility in the investment limits of individual stocks prescribed for mutual funds.

The present limits for equity funds was fixed quite some time ago and merits a re-look. However, these limits are not applicable to sectoral and index funds.

With a significant change in the market and the deepening of mutual fund schemes, which offer investors a wide-ranging choice, better flexibility could lead to more differentiated schemes for investors. This issue assumes importance given the fact that a diverse range of funds has developed specific stock preferences in the last five years.

The preferred ones: While SEBI had placed investment limits that pegged a 10 per cent cap for each stock in a scheme, in the last four years, quite a few funds have exceeded these limits. The stocks that have commonly figured in mutual fund schemes with weightages exceeding 10 per cent are those of Infosys, Satyam Computers, Zee Telefilms, Wipro, Himachal Futuristic and Global Tele-Systems to name a few. Perhaps the stock that figures most prominently is Infosys. And in an extreme instance, at one point in time, Himachal Futuristic accounted for 61 per cent of the net assets of Libra Leap, a growth fund of Taurus Mutual Fund.

SEBI wakes up: The situation of funds exceeding prescribed limits on one or two stocks has been alive for some time, but SEBI appears to have woken up to reality only early this year. The regulator directed Alliance Capital to ensure adherence to its SEBI regulations on this.

A look at the portfolio composition of the schemes such as The Alliance 95 Fund, Alliance Equity Fund and Alliance Capital Tax Relief as of July 31 shows that the funds have brought down their exposure to the prescribed limits. (But there are other funds such as Morgan Stanley and Birla Mutual Fund which have weightage in some stocks that even now exceeds the cap. These three funds have in particular been the ones to stand out in this regard. Much of it has to do with their early entry into stocks such as Infosys, Satyam Computer, Zee Telefilms, VisualSoft and Global Tele-Systems. Infosys has been among the top three holdings of the Morgan Stanley Growth Fund for almost four years now.

With the sharp spurt in prices, the bonus issues and stock splits, the weightage has risen to beyond the prescribed level, and, in most cases, exceeded 15 per cent. In the case of the Morgan Stanley Growth Fund, the Infosys' holding now accounts for 19 per cent of the net holdings.

This is after the fund sold an equivalent of 15.5 lakh shares of the present face value of Re. 1 each. It now has around 2.5 lakh shares. Despite such heavy paring down of exposures, the weightage continues to exceed the 10 per cent limit by a substantial margin. SEBI needs to look at the realities and review its regulatory framework.

Need to re-look: There is much to be said in favour of mutual funds having a diversified portfolio, prudence being a key factor. In this context, having some regulatory limits would be very much in order. Here SEBI is not in the wrong. But on a prospective basis, a re-look is warranted to provide some flexibility to fund managers.

If a particular fund spots would-be winners early on (as happened in the Infosys case by Morgan Stanley and Alliance Capital), even small holdings may raise the weightage to high levels when prices move up later. In such a situation, even if the prospects are very good, the fund would be forced to pare down the exposures. This cannot but hurt investors' interests.

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For instance, in the case of Morgan Stanley, had it retained its Infosys' holdings at the peak levels, the NAV of the fund would have been double what it is today. But the weightage might well have crossed 50 per cent, which would be excessive by any standards, even if the stock in question is a high quality one such as Infosys.

In such a case, the present structure penalises a fund for spotting a big winner early on. To avoid this denouement, fund managers need to have the incentive to select such a stock and capitalising on it through outsized gains.

Limits in two parts: SEBI should perhaps look at the possibility of having two-part systems for investment limits for individual stocks. Some such structure is used in mature markets as the US.

Individual stock limits could be made applicable for 75 per cent of net assets as part of the framework. This would ensure that the portfolio has at least eight stocks, providing ample room for diversification even if the fund manager goes to the prescribed ceiling on every stock in the portfolio.

The second part of the framework could be to leave 25 per cent of the net assets as free terrain for fund managers. They could even hold one or two stocks in this part of the portfolio. This would create room for heavy weightages in high-quality stocks that are expected to deliver good value over a period.

This would also be desirable since one or two stocks have a big weightage in widely followed indices such as the Nifty and Sensex, and without replicating the allocation for these stocks, outperformance may be difficult. A 75:25 system could be considered as it blends diversification and flexibility well rather than allow higher limits for stocks of a particular class, say, those that are part of an index.