Rationalization & Categorization of Mutual Fund

We all would be confused on the new rule issued by SEBI for mutual fund of consolidation of the funds to each other. We are confused on the thought that as an investor is my money safe to the investment I have made in that particular fund or not?

Before all this thought let us understand what this move by SEBI is and what  would be its impact on us as an investor and market.

Before thinking off as something irrelevant for people like us, let me tell you upfront that this is important. This is a big change that is taking place in mutual funds segment in India.

Let me take some effort to try and make understand this rationalization exercise undertaken by almost all the mutual fund. This will help you better to understand how bigger can be your portfolio in future that what it is today.

I may not be that proper or may miss few points but will try my best to cover as much as I can.

Till now in the Mutual Fund Industry have been accused of starting unnecessarily starting a large number of schemes with similar objective. This would be difficult for an investor to choose or make a decision on what their mutual fund scheme stand for.

For example :  A fund house might have 2 differently named scheme with same investment objective to be invested in risky companies (Midcap/Smallcap), which is unnecesary.

An another point of understanding is that till now many funds deviated from their objective of investment & till now what does mutual fund stand for is having a mutual or common goal & objective of investment.

For example: A fund has an objective to investment only the LargeCap companies but in order to generate more returns for the investor it may have also invested in Midcap and Smallcap Companies. As a investor it is good to some extend when market are in favorable position of upward move, bit it becomes difficult or more risky when market reaction falls and shows a downward move. For a LargeCap fund having more exposure to Midcap / Smallcap is very riskier on the side of an investor.We as an investor wont be complaining to have such portfolio as it might fetch us good returns but we will when things turn out as they are made to believe they will.

I hope you get the drift of what I'm pointing.

The industry regulator had been asking the AMCs (those who run mutual funds) to rationalize and simplify the big menu of hundreds of mutual fund schemes that were offered and also stay true to what their mandates were.

But I think "asking" didn't work.

So SEBI was forced to put out a circular on ‘Categorization and Rationalization of Mutual Fund Schemes‘ in October 2017 to ensure that the clean-up of mutual funds is done by force now.

Is this move by SEBI justified?

I think it is.

This simplification exercise is a step in the right direction and enables the right comparisons.

New Mutual Fund Categories & Sub Categories

Let’s see in some detail what the categorization is all about. Don’t worry. It’s not very complicated and you will have a clear understanding in next few minutes.

The first thing that has been done is to define 5 very clear groups to classify all the schemes. These 5 mutual fund categories are:

1. Equity Schemes – will invest in equity and equity related instruments
2. Debt Schemes – will invest in debt instruments
3. Hybrid Schemes – will invest in a mix of equity, debt and other assets related instruments
4. Solution Oriented Schemes – will have schemes like retirement schemes or children savings scheme
5. Other Schemes – will have index funds, Fund-of-Funds and ETFs

Now each of these 5 categories has its own sub-categories or ‘type of schemes’:

Equity Fund Types & Sub-Categories

Earlier, the definition of what is a Large Cap and what is mid cap and what is small cap was not defined by SEBI. So fund houses used to pick and chose whatever they wished depending on the in-house definition of market caps or their convenience!

But this has been standardized too in this exercise.

There is clear classification as to what is a large cap, mid cap or a small cap company:

• Large Cap Company: 1st to 100th company in terms of full market capitalization
• Mid Cap Company: 101st to 250th company in terms of full market capitalization
• Small Cap Company: companies beyond 250th company in terms of full market capitalization

Fund houses will be required to rebalance their scheme portfolios within a short period based on the updated list of market caps put out by AMFI. Here is the latest AMFI list of Indian companies by market cap.

To ensure strict adherence, the individual characteristics of each of these scheme types has been clearly defined now by SEBI. For example:

• Large Caps – to invest atleast 80% in large caps
• Large & Mid Caps – atleast 35% each in large caps and mid caps
• Mid Caps – atleast 65% in mid caps
• Small Caps – atleast 65% in small caps
• Multi Caps – atleast 65% in equities & no market-cap wise restriction
• Dividend yield – atleast 65% in equities but in dividend yielding stocks
• Value / Contra – atleast 65% in equities but a fund house can either offer a value fund or a contra fund but not both
• Focused – atleast 65% in equities but can have a maximum of 30 stocks
• Sectoral / Thematic – atleast 80% in chosen sector stocks
• ELSS (Equity Linked Savings Scheme)

So if a fund house is running a mid-cap fund, then atleast 65% of the portfolio has to be in stocks ranked between 101st and 250th by market cap. But the remaining 35% or lower (if higher than 65% allocated to mid caps) is available to have some large and small caps, which may be on their way up or way down to enter into the definition of mid-cap in near future.

So enough leeway has been given to include ideas other than pure sub-category demanded allocations as well. And this is fairly decent in my view and will still allow smart mutual fund managers enough flexibility to build a solid portfolio of stocks in-line with their fund’s investment objective.

And here is the best part.

To ensure that the number of funds is rationalized, a fund house is allowed to have only 1 type of scheme in each sub-categories mentioned above. Only exceptions that are allowed are in case of:

• Index Funds – can have as many schemes as there are indices
• Fund of Funds
• Sectoral / Thematic funds – can have as many schemes as there are sectors

Debt Fund Types & Sub-Categories

The earlier categorization of debt funds was found to be very broad and hence, more clear definitions have been drafted.

Now, the new types specify more targeted categories around the level of interest rate risk and credit risk taken by the funds. As a result, now the debt funds have quite a large number of sub-categories or types:

• Overnight funds
• Liquid funds
• Ultra-Short Duration funds
• Low duration funds
• Money market funds
• Short duration funds
• Medium duration funds
• Medium to long duration funds
• Long duration funds
• Dynamic bond funds
• Corporate bond funds
• Credit risk fund funds
• Banking and PSU funds
• Gilt funds
• Gilt funds with 10-year constant duration
• Floater funds

And here is the real difference between these funds:

• Overnight funds – holding portfolio with maturity of upto 1 day
• Liquid funds – holding portfolio with maturity of upto 91 day
• Ultra-Short Duration – holding portfolio with maturity 3-6 months
• Low duration – holding portfolio with maturity 6-12 months
• Money market – holding portfolio of money market instruments with maturity of upto 1 year
• Short duration – holding portfolio with maturity 1-3 years
• Medium duration – holding portfolio with maturity 3-4 years
• Medium to long duration – holding portfolio with maturity 4-7 years
• Long duration – holding portfolio with maturity more than 7 years
• Dynamic bond – can invest across durations
• Corporate bond – atleast 80% in corporate bonds (AA+ & above)
• Credit risk fund – atleast 65% in corporate bonds below AA
• Banking and PSU – atleast 80% in instruments issued by banks, PSU undertakings, municipal corporations, etc.
• Gilt – atleast 80% in instruments issued by government across periods
• Gilt with 10-year constant duration – atleast 80% in instruments issued by government across periods such that average maturity is 10 years
• Floater – atleast 65% in floating rate instruments

Then there are other categories too:

Hybrid Fund sub-categories

• Conservative hybrid funds – 10 to 25% equity allocation
• Balanced hybrid funds – 40 to 65% equity allocation
• Aggressive hybrid funds – 65 to 80% equity allocation
• Dynamic Asset Allocation – can vary without restrictions
• Multi-Asset funds – invest in atleast 3 assets with minimum of 10% in each.

If you have made it this far, congratulations.

And I know what you are thinking.

Aren’t these a little too much for cleaning up (simplification) exercise and rationalization of mutual funds?

Past Performance May Not Matter that much Now!

Yes. This is very important to understand.

Atleast for some mutual fund schemes, the past performance may not matter that much now!

If the fund is changing its mandate or its portfolio strategy, to accommodate categorization and rationalization, then its obvious that earlier strategy that resulted in past performance is no longer valid.

A new strategy has taken over. So you cannot expect past returns going forward as you don’t know how the new strategy will play out!

And that is why I feel that now, the problem of comparison based on past performance will begin. And mind you, this will not end until the time the funds accumulate a reasonable period of performance data post these changes. And this ideally means years.

This point is important and hence, I suggest you read last two paragraphs again if you didn’t get its importance.

If the fund has changed its nature, it means that whatever pattern it had set in past (with respect to return, risk, volatility, alpha, beta, whatever) is not valid going forward. It’s like a new fund has begun a semi-new life. 

This also means that if you depend on Star Ratings to pick funds, then that won’t work. Even earlier depending only on Mutual Fund Star Ratings was stupid. Now, it would be more so.

Also understand that even though rating agencies will come up with some or the other mathematical adjustments, the fact is that it will really take few years to have enough real data to correctly compare the funds in the category and (ofcourse rated by rating agencies).

Since the nature of fund is changing, its performance may be impacted as well. The ability of fund managers to generate alpha will be restricted in new regime as the choices they have will be limited due to category wise restrictions that will be applicable to them. So if slowly the fund you loved for its great performance starts reporting poor numbers, you would know what one of the causes might be.

I feel for new investors in mutual funds that will join in next few years. I hope they don’t take the wrong decision of judging old (be newly changed) funds only on basis of their past performance.

There is some hope for investor protection as to its credit, SEBI has directed fund houses to follow uniform rules to disclose past performance of their schemes post-merger.

This is how the past performance of the schemes would look post-merger:

• If two schemes have similar features, fund house will have to disclose the weighted average performance of both the schemes.
• If two schemes have different features, fund houses can highlight the weightage average performance of the surviving or retained scheme. However, fund houses can also disclose the past performance of scheme which was not retained post merger on request of investors.
• If two schemes merged to form a different scheme altogether, fund houses need not disclose any past performance.

(Source – recent SEBI circular)

There are and will be cases where a fund house has two similar looking schemes and both have a good track record to boast of. Now it will be difficult for Fund houses or AMCs to tweak them as shutting them down or merging will create a fund with assets that may be too large to manage within the scope of new restrictions and revised investment objective.

How does all this help Investors?

Earlier, for most investors it was difficult to gauge which is large cap and which isn’t. So with all funds having their own definitions, it was difficult to carry out comparisons correctly. A large-cap fund could easily have stocks that would be counted as mid-cap for a different fund. So this definition-setting will help eliminate cap-related confusion to some extent.

Another benefit is that over the years, just too many schemes had come into existence without a real need for. So this cleanup will reduce the unnecessary clutter.

Some of the scheme names were very misleading. And at times and to the uninitiated, it gave the wrong impressions of some kind of guarantees. With the restriction on the choice of name that the funds can have, the regulator has done its part to ensure that investors do not misunderstand the product and end up taking higher risk than they should.

This is something that used to happen a lot. A balanced fund ideally should be balanced. Right? That is what it is meant for. It was not to beat full-equity schemes. But unfortunately, many balanced schemes were unbalanced as they were stuffed with a lot more equity than was needed. So it was difficult to compare the two balanced fund simply on basis of returns when one was actually balanced and other was unbalanced.

The biggest advantage of this classification is that it will make mutual fund schemes comparable in a much better way. That is to say that comparison within their category and also provide decent relative comparison across category which would make sense.

One Thing That No one is Discussing

I may be wrong in my apprehension here but somehow, I feel that the style drift that will be curbed going forward (due to restrictions due to this new regulation), may seriously dent some fund managers ability to manage the funds like they used to.

See… every investor (even a fund manager) has a style. There are as many ways of picking stocks as there are investors.

1 plus 5 can be 6. So can be 3 plus 3.

Isn’t it?

So given a Market Scenario A, a fund manager may choose a different strategy than what he may choose in a different Scenario B. This strategy might be to go overweight on large caps in Scenario A and underweight on large caps in scenario B. This may be…and I repeat may be one of his sources of alpha generation and fund’s good performance. But now, this will be curbed as you understand.

How this will play is something that I don’t know.

It will be interesting to see. But I don’t see this being discussed in various forums. It’s like a known-unknown which we need to be aware of as an investor and as an advisor.

I agree that style drift is a risk which may not be worth everybody. But it is also not that no class of investors is willing to take that risk.

I am not sure but somewhere I have a feeling that by forcing only 1 fund per category per fund house, the regulator SEBI is perhaps not letting fund houses to innovate and experiment with various strategies. I may be wrong in this thinking but this is what I currently have in mind.

Stay Invested!!!! Happy Investment!!!!!