In this article, SEBI RIA Abhishek Kumar reviews SEBI’s Draft Circular on Revised MF Categorisation Rules.
About the author: Abhishek is part of a freefincal’s curated list of fee-only financial advisors and a fee-only India member. He can be contacted via his website, sahajmoney.com.
If 8 out of 10 stocks in your funds are the same, are you diversified or duped? SEBI is trying to settle this question.
Picture a crowded buffet where every dish looks different but tastes suspiciously the same. That’s what happens in the investment world: to stay in the top tier, active fund managers often end up holding the same set of stocks and sometimes in nearly identical proportions as their competitors—entirely defeating the purpose of investing in active funds to beat passive ones.
Warren Buffett calls this the “institutional imperative.” You can’t entirely blame fund managers; they, too, have higher-ups to report to, and if they diverge too far from peers, unitholders may abandon their funds for those that are temporarily outperforming. It’s a bit like students copying the class topper so their parents don’t scold them with, “Look at Sharma ji ka beta. He topped the class and you didn’t.”
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The result is “false diversification,” where portfolios overlap heavily. SEBI has noticed this, and it’s one reason it released a consultation paper last week that could have a lasting impact on India’s ₹ 74-lakh-crore mutual-fund universe. Large-cap funds often share 70 – 80 % of their holdings, so investors are effectively piling extra helpings of the same recipe. Meanwhile, other asset classes such as REITs, InvITs, and so on are ignored. SEBI’s draft aims to reduce these overlaps and deepen the market across asset classes.
What are the major changes proposed by SEBI ?
One of the most significant proposals introduces strict portfolio overlap limits. Currently, fund houses can offer either a Value fund or a Contra fund but not both. The new rules would allow both, but with a crucial catch: no more than 50% of their portfolios can overlap. For sectoral and thematic equity schemes, the same 50% overlap limit applies when compared to other schemes in the category (excluding large-cap funds).
This overlap monitoring would happen at the time of New Fund Offers (NFOs) and subsequently on a semi-annual basis. If funds exceed the permitted overlap, asset management companies must rebalance within 30 business days or face the consequence of offering investors an exit option without any exit load.
Perhaps the most debated proposal allows mutual fund houses to launch additional schemes within existing categories. This would break the sacred “one scheme per category” rule that has governed the industry since 2017. The conditions are stringent: the existing scheme must be over five years old with assets exceeding ₹50,000 crore, and it must stop accepting new investments after the additional scheme launches. This could create “orphan funds” where the original scheme only faces redemptions, potentially hurting existing investors.
Finally, the draft proposes allowing mutual funds to invest their cash holdings in a diversified mix including REITs, InvITs, gold, and silver instruments. This could provide fund managers with more tools to optimize returns while maintaining the fund’s core investment mandate.
How does this affect average unitholders?
The most alarming issue is what happens to investors who remain in the original scheme once a Series 2 launches. With only redemptions and no new inflows, managers may be forced to sell assets at unfavourable times, hurting returns. As AUM shrinks, fixed costs are spread over a smaller base, further eroding performance which effectively penalizes continuing investors.
Ironically, the rule may reward underperforming giants. A large-cap fund with ₹ 60,000 crore in AUM but poor five-year returns could launch a Series 2 with the same strategy yet a clean performance slate. New investors see upside without the baggage, while the AMC still earns fees on the old fund it gets an incentive for “empire building” rather than genuine innovation.
An investor holding three large-cap funds for diversification would gain clarity on overlaps, but if one of the fund house launches a Series 2 fund, the investor must decide whether to switch or stay in the now-orphaned scheme. This two-tier treatment depends solely on entry timing.
SEBI is accepting public comments until August 8, 2025; final rules may arrive late 2025 or early 2026. Existing schemes will get six months to realign, so full effects may surface by mid-2026. Submit feedback here: https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes
Conclusion
While SEBI might be aiming to improve transparency and cut portfolio overlap, but the proposed cure risks creating a two-tier system that disadvantages long-time investors while letting AMCs bury underperformance with shiny new launches. Retail investors should track these developments, review overlap data once available, and decide based on AUM thresholds whether to stay or switch if their fund becomes eligible for a Series 2. Above all, pursue genuine diversification rather than collecting funds that secretly serve the same dish.