(Bloomberg) -- India’s markets regulator has asked mutual funds to take steps to protect investors in small- and mid-cap plans amid concern that some parts of the nation’s $4.5 trillion stock market have become overly exuberant.

The Securities and Exchange Board of India has prescribed measures, such as potentially moderating flows into such funds and safeguarding unit holders from sudden redemptions, according to a letter sent to fund houses by the Association of Mutual Funds in India on Feb. 27 and seen by Bloomberg News. Final decision on what measures to implement are left to the funds, who have 21 days to implement the policy.

A spokesperson at the mutual fund body declined to comment, while calls made to Sebi’s media office went unanswered.

The MSCI India Small Cap Index fell as much as 1.1% on Thursday, adding to a 1.6% slide in the previous session. Small- and mid-sized stocks have powered the record rally in Indian shares in the past year, with funds focused on this segment getting nearly 40% of net equity inflows of $19.5 billion in 2023.

The flows could have an outsized impact on small caps’ prices as such stocks have lower market depth due to higher promoter ownership in India, said Bloomberg Intelligence analyst Nitin Chanduka. On average, promoters own 55% of the Nifty smallcap gauge, compared with 40% in the broader index, BI data show.

“When too much money chases less number of stocks, there is demand supply mismatch and this could result in stocks going up artificially,” said DP Singh, a deputy managing director at SBI Funds Management Ltd., which held $77.9 billion in equities as of January. 

Calling it more of a “cautionary message” to funds and investors, Singh said most asset managers are voluntarily taking measures such as accepting fresh investments only via recurring monthly investment plans.

Kotak Asset Management Co. this week imposed limits on flows on recurring plans in its small-cap fund, citing the sharp surge in this segment that has led to “valuation distortions” in some cases.

Sebi Chairperson Madhabi Puri Buch in January said the regulator is stress-testing such funds to gauge their resilience in the event of sharp market declines or sudden redemptions.

“There’s a strong possibility that many funds will be influenced to pause lumpsum investments in these segments for sometime,” said Abhilash Pagaria, an analyst at Nuvama Wealth Management Ltd. “SIP flows shouldn’t be impacted,” he said, referring to recurring monthly investment plans.

--With assistance from Ishika Mookerjee.

(Updates with details and more comments.)

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