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Introduction

In September 2020, SEBI mandated that multi-cap mutual funds must invest at least 25 % each in large-cap, mid-cap and small-cap stocks. This “25% allocation rule” aimed to enforce diversification. But as markets evolve, fund houses and investors question whether this rigid constraint is hampering fund managers’ ability to adapt tactically. The core debate: is the rule protecting investors or handcuffing professionals?

 

Background / Context

What is the SEBI 25% rule and how did it come about?

Historically, multi-cap funds in India had broad flexibility in allocating across sectors and capitalisations. Fund managers could tilt heavily toward large-caps or small-caps based on market outlook. That changed with SEBI’s circular dated 11 September 2020, which introduced two key constraints:

1. Equity minimum raised: At least 75 % of total assets must be in equity and equity-related instruments, up from 65%.
2. Minimum per-cap allocation: At least 25 % of the portfolio must be in each of large-cap, mid-cap and small-cap companies.

The rationale was rooted in regulatory concerns:

• Many multi-cap funds were heavily skewed toward large-cap holdings (80 %+), reducing true diversification.
• The name “multi-cap” risked being misleading when the small-cap allocation was negligible.
• Benchmarking was inconsistent: some funds used large-cap indices despite multi-cap claims.

The regulation also created a complementary category — flexi-cap funds — which enjoy full flexibility in allocation (but with a 65 % equity floor).

Why this matters now

Since the rule’s adoption, the multi-cap vs flexi-cap debate has intensified. Critics argue the 25 % rule imposes structural rigidity, while supporters consider it a guardrail against overconcentration. With market cycles characterized by rotations (e.g., small/mid to large or vice versa), the debate affects returns, fund flows and portfolio strategies across the mutual fund industry.

Moreover, in recent years, market conditions have seen sharper divergences across capitalisations. That makes flexibility and nimbleness potentially more valuable — raising the central question: is the 25 % constraint now a bug, not a feature?

 

Detailed Explanation of the Debate

The regulation in force

Under current rules:

• Multi-cap funds must allocate at least 25% each to large, mid and small-caps (totaling 75%) and can place the remaining 25% in any of those or in debt/cash.
• Flexi-cap funds must invest at least 65% in equities but have no restrictions on allocation between large, mid or small caps.

What has been challenged or questioned

Critics and fund managers often raise the following points:

• Strategic inflexibility: Even in scenarios where small-caps are under pressure, a multi-cap fund must maintain 25 % exposure. That may weigh on performance during down cycles.
• Inefficient capital deployment: When one segment has superior risk/return prospects, fund managers can’t fully tilt toward it beyond the discretionary 25%.
• Rebalancing cost and churn: Maintaining fixed minima necessitates frequent rebalancing, which can incur transaction costs and tax impact.
• AUM scale constraints: Large funds struggling to scale up small-cap exposure quickly may find it impractical to hit 25% in small or mid segments. As Morningstar’s commentary noted, many large multi-cap funds may prefer to reclassify into large+mid schemes rather than expand small-cap holdings.
• Investor preference and comparability: When many multi-cap funds deviate very little from 25-25-25, the distinction between them narrows, reducing competitive differentiation.

Defending the rule

Supporters point out:

• Guaranteed diversification: The rule helps prevent overconcentration in large stocks and protects investors from manager bias.
• Standardization and clarity: All multi-cap schemes must adhere to the same floor, avoiding misleading product naming.
• Risk mitigation in downside phases: Having mandated exposure into small/mid can capture rebound potential and cushion against large-cap-only downside.

To quote industry observers:

“Multi-cap funds have a structural constraint, with 75 % of the portfolio locked equally across large, mid, and small-cap stocks, leaving limited room for tactical asset allocation.”
— Yash Sedani, AVP, Investment Strategy at 1 Finance

 

Impact Analysis

Who stands to gain or lose

Beneficiaries:

• Investors seeking diversification guarantees
  Those wary of concentrated large-cap exposure may appreciate the mandated floor in smaller segments.
• Mid-cap and small-cap sectors
  Funds must allocate a minimum exposure here, which can support inflows to less favored mid/small stocks.

Potential losers:

• Fund houses and managers
  Particularly those who believe in high conviction or tactical allocations may find their hands tied.
• Large-cap momentum biases
  In strong bull phases favoring large-caps, multi-cap funds cannot fully ride the trend, potentially underperforming flexi-cap counterparts.
• Scale-focused funds
  Very large AUM funds may struggle to rotate 25 % into less liquid small/mid stocks without market impact.

Practical implications

For Asset Management Companies / Fund Houses

• Must manage rebalancing costs and turnover.
• Need to rationalize which existing multi-cap schemes remain viable; some may convert to flexi-cap or to more narrow categories.
• Marketing differentiation shrinks — many funds will tend to cling near floor allocations.

For Individual Investors / Taxpayers

• Investors in multi-cap funds cannot expect aggressive capitalisation tilts beyond the discretionary 25%.
• Returns may lag flexi-cap funds in certain cycles; investors must be aware of the structural cap on opportunistic weighting.
• Tax efficiency may suffer due to extra churn from forced rebalancing across caps.

For Auditors / Chartered Accountants / Compliance teams

• Fund audits and compliance checks must verify adherence to 25% minima at all times.
• SEBI compliance risk increases if any fund dips below the prescribed floor — triggers regulatory scrutiny.
• Reporting must clearly disclose allocation percentiles and rebalancing rationale to stakeholders.

 

Common Misunderstandings

• Fund managers are not free to deviate below 25% in any cap segment.
• The rule does not require exactly 33.33 % in each — only a minimum 25%.
• The remaining 25% of the fund’s assets can be allocated anywhere (including debt or cash).
• Flexi-cap funds do not have this 25% constraint — they offer full allocation discretion.
• The 75% equity floor is separate from the segment minima — both must be satisfied.

 

Expert Commentary

From my perspective, the 25 % floor was a well-intended regulatory correction to curb overconcentration. However, markets and fund strategies have become more dynamic post-2020, and rigid minima now risk stifling agility. The optimal path forward may lie in a more graduated or conditional floor, perhaps adjusting the minima thresholds in bull versus bear cycles or allowing temporary deviations under disciplined guardrails.

For instance, fund houses might lobby for a “buffer band” — say 20–30% rather than a fixed 25% — or permit temporary undershoots during market stress. Otherwise, the trade-off will persist: diversification versus strategic agility.

 

Conclusion & Action Steps

The 25 % allocation rule for multi-cap funds is double-edged. On one side, it enforces diversification discipline and protects investors from overexposure to large-cap bias. On the other, it constrains skilled fund managers from making aggressive tactical plays. As market cycles widen, this rigidity may create underperformance and hamper differentiation.

Moving ahead, policy makers, AMCs and industry bodies should revisit whether a one-size-fits-all floor is optimal for all market environments. Potential reforms could include:

• Flexible brackets (e.g. 20–30%) rather than a fixed floor
• Allowing temporary breaches under strict conditions
• Periodic calibration of the floor based on volatility regimes

For investors, the takeaway is clear: if you prefer a fund with tactical allocation freedom, flexi-cap funds may offer a better trade-off. For more disciplined diversification, multi-cap funds remain valid — provided you understand their structural limits.

 

FAQs

1. Why did SEBI introduce the 25% allocation rule?
SEBI observed that many multi-cap funds were skewed toward large caps beyond 80%, undermining their “multi-cap” identity and misleading investors. The 25 % rule enforces minimum exposure to mid and small segments and enhances portfolio diversification.

2. Can a multi-cap fund invest 40% in small-caps if it wants?
Yes. The 25 % is a floor, not a cap. The discretionary 25% leftover can be allocated as per the manager’s view—even all in small-caps.

3. Is flexi-cap superior to multi-cap now?
There is no universal answer. Flexi-cap offers flexibility and can outperform in trending phases, but it also carries greater discretion risk. Multi-cap offers structural safety but may lag in directional markets.

4. Does forced rebalancing across caps hurt tax efficiency?
Yes, frequent rebalancing between large, mid and small stocks may generate short-term capital gains, increasing tax burden and reducing net returns.

5. Will this rule be revised?
The industry is actively debating softening the rule — e.g. allowing buffer bands or conditional deviations. But as of now, SEBI has not signalled a forthcoming change.

 

References / Source Links

• SEBI mandates multi-cap funds must invest 25 % in each cap segment
• AMFI scheme classification details
• Challenges and critiques of the 25% rule / Morningstar commentary
• Flexi-cap vs multi-cap comparisons and industry commentary