How mutual fund selection is affected by Sebi’s Mutual Fund Categorization rules

Published: April 3, 2018 at 10:10 am

Last Updated on December 28, 2021 at 6:37 pm

Most readers may be aware that SEBI has laid out norms for mutual fund categorization and many AMCs have fallen in line. It is frustrating that the big AMCs like ICICI, HDFC, Franklin and others have delayed conforming to this order. Makes me want to speculate that they have deliberately waited for the financial year to end to avoid mass switching or redemption. In this post, I discuss why and how mutual fund selection is affected by these rules and what existing investors should do if a scheme announces a fundamental change in attribute.

For the record, HDFC has announced the changes for their debt funds on March 28th. If you are an investor, you will get an email. If you an enthusiast, you can look in the downloads (addendum) or news sections of the amc websites for details. If you are wondering what these regulations are, you can start here: SEBI’s Mutual Fund Scheme Categorization: Pros and Cons. These are the relevant circulars: SEBI circular no. SEBI/HO/IMD/DF3/CIR/P/2017/114 dated October 6, 2017 and circular no. SEBI/HO/IMD/DF3/CIR/P/2017/126 dated December 04, 2017 on “Categorization and Rationalization of Mutual Fund Schemes”.

How do these rules affect mutual funds?

The investment mandate, strategy, asset allocation and benchmark of several funds have changed. This is known as a change in a fundamental attribute. When this happens, as per SEBI rules, the fund house must provide a load-free exit option to unitholders. Many funds have been merged because SEBI now allows only one fund per category.

How do these rules affect existing investors?

Since it is a fundamental change in attribute, the AMC will offer existing investors a time window to exit without load (but tax is applicable as usual). If no action is taken by the investor, then the scheme will either be merged with another, the scheme name changed or the mandate changed as declared by the AMC. In most cases, the risk profile of the new scheme is not different from that of the old. So existing investors will not be affected too much. If the very nature of the fund has changed or will be merged into a different fund, then investors must consider the exit option on a case by case basis. When you review performance, keep this change date in mind.

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How do these rules affect mutual fund selection or new investors?

In on stroke, these rules have made past performance irrelevant, be it returns, risk, downside protection, alpha, Sortino, etc. Anything that can be calculated with the NAV is no longer relevant IF the fund has changed its nature – asset allocation, strategy or benchmark. In other words, from the announced date of change, we will be looking at a new fund.

Trash mutual fund star ratings because of SEBI categorization rules

This means, from that date, star ratings are more useless than they already are. Why? Because star rating is a peer comparison. When the many members in a peer group change colour, you cannot use ratings that rely on past performance. It simply make no sense to look at star ratings and choose a fund (it never did) when the fund’s future management is different from what it was in the past. This is the reason why I did not publish my monthly risk-reward consistency screener last month. This month, I shall only publish it for funds that have not changed investment strategy.

Even if you are die-hard star ratings fan, please recognise that it will take the next 3-5 years for funds in the new category to be compared and rated. So this is the best time to ditch them. Read more: Mutual Fund Star Ratings are Flawed, but Investors are to blame for taking them at face value

Which funds have not changed because of this SEBI categorization?

There are two varieties here: (A) Funds for which the AMC has clearly mentioned that there will be no change. For example, PPFAS Value Fund, All funds of Quantum, most funds of MOST and Mirae. Any more? Please comment below. (B) There is a change in strategy, asset allocation or benchmark, but these changes do not seem significant. Again this has to be decided on a case by case basis and this choice is purely qualitative. So you will have to take a deeper look.

So how should I now select mutual funds now?

The key steps have not changed. Define your need —> Decide asset allocation —-> Decide on product categories with new rules (within a month all AMCs should have complied)—-> Shortlist a set of funds from a select category based on their past* downside protection consistency —-> Look at the changes to each fund in the shortlist  and pick one you are comfortable with. There is not much else you can do.  * For now, the past will have to be prior the categorization rules. But this will change with time.

Does the mutual fund review process change now?

No. Once you make a selection or if you are an existing investor, use the new benchmark as primary outperformance yardstick and the old benchmark as second outperformance yardstick. Never look at star rating changes as they look at a different time window than that of your investment. Always look for consistent outperformance in return and downside with both benchmarks from the date you started investing in the fund. If there are reasonable, nothing more need be done – other than vary asset allocation as per need and manage risk in the portfolio. Read more: How to review a mutual fund portfolio

Other points to consider

Check if these star rating portals have bothered to comply with SEBI fund classifications. If they have not, do not take the grouping seriously. Even if they do, never ever compare peers. This is a waste of time and energy and will only stress you out.It will take several months for things to settle down. So do be patient.

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