Category: Investing

If you are an existing mutual fund investor, you would already be aware that a lot of mutual funds schemes are being renamed, recategorised, merged or getting their mandates (investment objectives) changed.

Technically, this is being referred to as ‘Categorization and Rationalization of Mutual Fund Schemes‘ in India.

Before you write this 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 in India.

Make some effort to try and understand this rationalization exercise that all mutual funds are going through. This understanding will help you in the long run when your portfolio will be much bigger than what it is today. 🙂

I am no expert but let me try and make sense of this in as simple terms as possible.

Since long, the mutual fund industry has been accused (and in a way rightly) of starting an unnecessarily large number of similar schemes. This has created a lot of confusion for investors who are unable to understand what their mutual fund schemes really stand for. For example – a fund house can have two differently named schemes but which both focus on large caps with significant overlap of strategy and portfolio. This is unnecessary.

Another issue was that many funds deviated from what their mandate was. For example – a large cap fund is expected to invest primarily in large cap companies. But in search for higher returns, many large cap funds took unnecessary exposure to smaller caps. This works well to boost returns when markets are rising. But can be disastrous when markets take a turn. Investors at their end, practically are not getting what they are promised. A large cap fund having more money invested in small and mid caps is not fair to the investors. Ofcourse they don’t complain when returns are higher. 😉 But they will when things don’t turn out as they are made to believe they will.

I hope you get the drift of what I am pointing to.

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 that ‘asking’ did not help much.

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. If interested in these new SEBI guidelines for mutual funds 2017 2018, you can read about them in detail in SEBI’s circular here and here.

At the time of writing of this article, the fund houses have either already recategorised and rationalized the fund schemes or are in process of doing it after getting SEBI’s approval. These changes will take effect beginning from early 2018 to about mid-2018.

Is this move by SEBI justified?

I think it is.

We cannot deny that the number of mutual fund schemes on offer had become unnecessarily large. Most investors are extremely confused by the sheer number of schemes on offer and what actually is the difference between them. To be honest, even I have had my own share of wtf moments on finding such unnecessary large overlaps between different schemes.

So the new system aims to bring uniformity to the schemes and ensures that there is a specific and clear categorization of schemes. Now, comparisons will be among the right things and hopefully, using the right and relevant numbers.

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

• Large Caps
• Large & Mid Caps
• Mid Caps
• Small Caps
• Multi Caps
• Dividend yield,
• Value
• Contra
• Focused
• Sectoral/thematic
• ELSS (Equity Linked Savings Scheme)

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

If these percentages seem a little too tight to you from fund manager’s perspective, please understand that enough relaxation is provided for decent portfolio flexibility.

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

Solutions oriented Schemes

• Retirement Planning
• Children Future Planning

Other Schemes

• Index funds
• ETFs (Exchange Traded Funds)
• Fund of Funds (FoF)

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?

🙂 🙂

Some feel that since the intention was to reduce the complexity bogging down the mutual fund industry, the new classification system has far too many schemes to be called ‘simple’.

I agree to an extent.

But this level of detailed categorization was needed. And I am not joking.

This was needed to ensure that fund houses did not take investors for a ride and offer them the same wine in a different bottle without changing much on the label too!

Debt funds are far more complex animals than equity funds. So due their inherent structural complexity and the fact that they are designed to cater to a wide variety of investor categories, a high number of fund types is reasonably justified. Things might change more in future. But as it’s just a start, it seems to be fine for time being.

You already knew that Mutual Fund investments are subject to market risks, read all scheme related documents carefully. But atleast for sometime now, Mutual Fund investments will be additionally subject to category-wise understanding too. So please (re)read the new scheme related documents (very) carefully. 🙂

Let’s move on to another important aspect that many investors use as the criteria for mutual fund selection – Past Performance of 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.

Finally…

It has been a long post. But I wanted to write it in detail as it is an important development for investors.

Please understand here that no classification scheme is perfect.

There will always be new ways to improve the classification in each iteration. But as I said, this is a good start and a step in the right direction.

There are few blind spots like restriction on the ability of some fund managers to generate outperformance using their existing styles. But that I guess will be compensated by other means. I am not sure which or when but I presume good fund managers will do good in any regulatory environment.

To be fair, this is a new development and that too a big one.

So AMCs will take some time to stabilize their portfolios, reclassify their schemes, etc., etc. They have already started sending emails (which you too would be getting from them in your inboxes).

So without mincing words, let me say that this is a period of uncertainty for existing investors. But do not worry. Things are changing for the good.

Having said that, it is very clear that even after the new categorization, the number of mutual fund scheme categories is still very large. More than 30-35 I guess. So it would require some bit of understanding and effort to make proper mutual fund selections. For some, this will be easy. For others, it won’t be. If you have doubts, then it’s best to take help of professional advice.

So what is the best course of action?

Take this as an opportunity to clean up your portfolio, realign it in line with actual requirements and in line with your correct risk profile and investment horizon. Also now you can better compare the actual risk-reward scenario among similar schemes.

What will happen to the funds you have invested in?

It is possible that your fund may continue as it is with no changes. It is also possible that the scheme may get merged with another scheme in the same category. It is also possible that the investment objective of your fund may change.

But remember that just because a mutual fund scheme is changing to adjust to the new SEBI-proposed amendments, doesn’t mean that it should be thrown out of your portfolio. As long term investors, you must remain calm and have a relook at the funds in line with your goals (free financial goals excel download). If the amended scheme still fits into the suitability criteria, then there is no need to make unnecessary changes.

So do not be in a hurry to exit and re-enter funds at this stage. More so just on basis of returns or change in fund attributes.

Give the AMC or fund houses some time to allow their funds to settle into their new categories or new mandates. Remember, that depending only on mutual fund ratings even earlier was not a great idea. Now, it is more useless if the comparison is done with new category peers based on the past data.

Mutual funds still remain the best way for common investors to benefit from various assets (more so from equity). That too for common people who need a simple yet powerful method to invest systematically.

These changes might seem a bit too much in near term but will set the base for better industry structure in long term. Do not hesitate in contacting an advisor if you lack clarity.

These recent changes alongwith the impact of LTCG tax on equity are big changes that we face. It’s best to understand the realities without blindly believing in what others are saying.

It’s your money and your responsibility. Make the effort to protect it and grow it.

So take your time. Understand the whole impact of Categorization and Rationalization of Mutual Fund Schemes in India. And also about the impact of LTCG tax on equity investors.

There is no hurry to act now.

More so if you are long-term investor investing for your real personal financial goals. But as time progresses, a knowledge of these changes will help you better manage your investment portfolio.

Happy investing!

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