Categorization & Rationalization of Mutual Fund Schemes by SEBI

SEBI has proposed a regulation for categorization & rationalization of Mutual Fund Schemes…

There are around 1200+ open-ended mutual fund schemes, Out of this, one-third comprise of equity funds, and one-fourth comprise debt funds. The sheer volume of these mutual fund schemes is confusing to an investor.

Many fund houses have had multiple schemes with almost the same investment strategy making it difficult for the investors to choose.

Some of the schemes launched by the fund houses had their own unique names for their investment strategy. E.g. flexi-cap, multi-cap, emerging bluechip, etc. It is highly confusing for an investor to understand a fund’s strategy or category.

Categorization

The fund houses themselves decided on what stocks qualified as large cap, mid cap, and small cap, and there was no uniformity across the AMCs. Also, there was no set definition for the percentage of stocks of a particular market a fund can hold. For example, some large-cap funds invested 50% in mid and small cap stocks but were still categorized as Large Cap Fund.

So, the mutual fund industry desperately needed a guideline to categorize and rationalize their schemes.

The Securities Exchange Board of India (SEBI) issued a circular in Oct 2017 on Categorization and Rationalization of Mutual Fund Schemes. The circular contains a set of regulations for all the mutual fund schemes to bring uniformity in the characteristics of similar schemes.

The regulation sets the below terms for all open-ended mutual fund schemes.

  1. The schemes are broadly classified into the following groups
    • Equity Schemes
    • Debt Schemes
    • Hybrid Schemes
    • Solution-Oriented Schemes
    • Other Schemes
  1. The equity schemes can have three sub-categories – Large Cap, Mid Cap, and Small Cap.
    • Large Cap – 1st – 100th company in terms of market capitalization
    • Mid Cap – 101st – 250th company in terms of market capitalization
    • Small Cap – 251st onwards in terms of market capitalization.

    EQUITY

  1. The debt funds are categorized based on the maturity of the underlying securities.

fresh

  1. Only one scheme per category is permitted except
    • Index Funds and ETFs tracking/replicating different indices
    • Fund of funds having different underlying schemes
    • Sectoral/Thematic funds investing in different sectors/themes

Hybrid

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  1. For the solution-oriented schemes, a lock-in period has to be specified.

SOLUTION

  1. Mutual funds can offer either Value Fund or Contra Fund.

Other

Also read: Beginners guide to investing in mutual funds

What do these regulations mean to AMCs?

may impact the AMCs as follows:

  1. If there are multiple schemes under the same category, they have to be merged.
  2. Since the definition of large cap, mid cap, and
  3. Many funds have to be renamed to a simpler name that indicates either their sub-category or investment strategy.For example, MIP (Monthly Income Plan) was actually a hybrid fund, but the investors confused it to be something similar to monthly income scheme. MIP schemes will now be known as conservative hybrid schemes.
  4. If the fund house offers both Value fund and Contra Fund, they have to choose to keep one of them.
  5. Among debt funds, a corporate bond fund can invest only in AA+ and higher rated instruments. Only a credit risk fund can invest in AA and lower-rated

Though the impact of these regulations seems to be more on the operational side, there are many challenges faced by the fund houses to implement these norms.

  1. There are many similar/duplicate schemes of the same fund house which have done exceedingly well. Merging them would not go well with the investors.
  1. For equity funds, the market capitalization for the previous six months has to be considered. So, the stock holding in the previous six months of a fund holds the key to determine the category of the fund.
  1. The possible impact on the performance of existing funds due to a merger.
  1. Likelihood of higher expenses if portfolio churn is required.
  1. Investor diffidence if any of the existing schemes have to be discontinued.

How do investors benefit from these new norms?

The very purpose of these new norms is to benefit the investors.

Ease of choosing a fund

Since the fund houses now are required to classify the schemes as defined by SEBI. Its easy for an investor to choose a fund according to the category and his risk profile.

No change in fund objective

The investor need not worry about any change in the mandate of a fund; Since the categories and sub-categories are defined, a scheme has to strictly adhere to the rules specified for that category. If there is any drastic change, then it has to be informed to the investors, and the categorization has to be changed.

Simpler labelling of debt funds and hybrid funds

Debt funds have been sub-categorized further based on the maturity tenure and credit rating of the underlying securities. A total of 14 sub-categories have been made, with clear specifications on the maturity tenure of the securities held in a fund, and on the percentage exposure to bonds of different credit ratings.

Hybrid funds are required to be labelled as conservative, balanced and aggressive. Fund names like MIPs have to be removed, as they are misleading.

One definition to classify equity funds based on market capital

Earlier, each fund house defined large cap, mid cap, and small cap according to their own rules. Now, there is a clear definition of what should compromise large-cap, mid-cap, and small-cap funds.

How can these norms affect investors?

Though these norms have been made for the benefit of investors, investors might face some challenges when the fund houses make changes to comply with the norms.

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  1. If the fund house decides to discontinue any of the schemes, the investor will have to redeem their investments even if they have not the intention of doing so. They might have to pay tax on the capital gains as well.
  1. Since the category of an equity fund is determined by the market capitalization of the stocks held in the previous six months, the category of the fund and hence, the investment strategy may change abruptly. The investor will be at a disadvantage as she might be exposed to an investment that is unsuitable for her.
  2. To comply with the new norms, the funds might churn their portfolio to align with their category. For an investor, it requires an immediate review of the portfolio to rebalance it
  1. If a scheme is merged with another, the investor gets the option to redeem/ switch out of units from the scheme, during the exit period. It may entail capital gain/ loss in the hands of the unit holder.
  1. In case of NRI investors, TDS shall be deducted in accordance with the applicable tax laws, upon exercise of exit option and the same would be required to be borne by such investor.

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Final Words

The new regulations on Categorization and Rationalization of Mutual Funds by SEBI is a welcome move. It will benefit the investors to choose a fund according to their risk profile, compare similar funds from different AMCs easily, and not worry about the risk of fund manager deviating from the set norms.

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