The mutual fund industry in India has emerged as an attractive investment proposition for investors as can be seen from the sharp growth in inflows in recent years. However, despite this sharp growth, the industry remains a maze for the uninitiated investor given the large number of schemes (837 open-ended schemes1) and absence of standardization in the offerings. To bring in uniformity and avoid duplication, market regulator, the Securities and Exchange Board of India (Sebi) has introduced a new system of fund classification. This should get implemented by the mutual fund industry in coming days and is aimed at simplifying and bringing uniformity to the different types of funds. This article explains this change and looks at how it will impact investors given that they will need to take cognizance of the new categories and may need to realign their portfolios in the immediate term.
Well-defined new fund categories
SEBI has standardised the scheme categories and brought in uniformity in the characteristics of similar types of schemes offered by different funds. Accordingly, SEBI has classified open-ended schemes under five broad groups: equity, debt, hybrid, solution-oriented, and others (index, exchange-traded funds or ETFs and fund of funds). It has further classified 10 categories under equity funds, 16 in debt funds, six in hybrid funds and two each in the solution-oriented and other funds groups, specifying the exact asset and risk allocation and norms for each scheme type.
The regulator has also identified portfolio characteristics within the categories. So within equity funds, large-cap funds can invest in the top 100 listed companies based on the average full market capitalisation of the previous six months, mid-cap funds can invest in the 101st to 250th company, and small-cap funds in the 251st company onwards.
Similarly, Sebi has prescribed norms for the different types of debt, hybrid, solution and other funds. Within debt funds, there are six categories based on the duration of the portfolio. So, an ultra-short-duration fund will have a Macaulay duration2 between 3 and 6 months while a long duration fund will have a Macaulay duration of over 7 years. Also, hybrid equity funds are now demarcated based on asset allocation into conservative, balanced and aggressive hybrid funds. Additionally, the regulator has also clamped down on the number of funds in as single category. Going forward, fund houses are permitted to have only one scheme of each type, except in the case of index funds, ETFs, fund of funds and sectoral and thematic funds.
Investors to benefit from uniform norms across categories
The new rules will require mutual funds to reclassify their scheme types and realign their existing schemes in terms of their investment objective and strategy, their asset allocation and risk profile, and also their benchmarks to meet the new norms. This may entail changing the fundamental attributes of some schemes or merging and winding up others. For the investors, the benefit is that uniformity and standardization would enable to better compare schemes across fund houses and take informed investment decisions. It will also help them to better understand the risks, returns and performance of their schemes. For instance, unlike the broad income fund category, debt funds are now categorised as corporate bond, credit risk, dynamic bond and banking and PSU funds. A corporate bond fund cannot take undue risks by investing in lower rated bonds as distinct from a credit risk fund. Similarly, a large-cap equity fund must invest at least 80% of its portfolio in large-cap stocks and can’t change its mandate by taking on more mid-cap stocks to boost performance.
Review and realign portfolios
As fund houses begin to realign their schemes to the new norms, investors are bound to face some hassle initially. Hence it is imperative for investors to review their mutual fund portfolio and check if the reclassified schemes in their portfolio are aligned to their investment goals and risk-return expectations. In the long run, however, investors are bound to benefit from the simplification of and uniformity in fund categories.