Last Updated on August 30, 2021 at 8:57 am
In October 2017, SEBI announced its Categorization and Rationalization of Mutual Fund Schemes. This was done to bring some uniformity in funds belonging to the same category by restricting their asset allocation. SEBI’s motive was to help investors differentiate among fund categories and make better decisions. A year after all fund houses complied with the new rules, let us find out if it has helped investors or made things worse?
When the rules were first announced, in two circulars, Oct 2017 and Dec 2017, I wrote an article that explained the revised scheme categories, listed pros/cons and believed it was a step in the right direction and followed it up with: How investors should choose mutual funds after the new rules kick in. Today, I am not so sure if these rules make a difference. Worse, I doubt that they have made things worse.
Impact on equity schemes
There are a few positives here. (1) Forcing large cap funds to invest 80% of assets in the top 100 stocks by market cap has made investors realise the importance of index funds. However, it should be noted that large cap funds were struggling before the rule was introduced: Only Five Large Cap funds have comfortably beat Nifty 100!
(2) Categories like Value style, Contra, dividend yield, thematic, sectoral are reasonably well segregated.
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(3) Mid cap and small cap funds with 65% minimum allocation in each are also reasonably separated although one can see small caps add higher than the allowed allocation to mid caps in times such as this. Investors do not mind as long as the going is good!
The one big negative here is the lack of distinction between large and midcap funds and multicap funds. While large and midcap funds should hold 35% of each type there is no restriction on the multicap category. So within the same category, you can find funds with large cap tilt and funds with reasonably uniform distribution. This makes it hard for investors to choose. Also, the asset allocation is AUM dependent with large cap exposure increasing with fund inflows.
Impact on debt funds
We have seen credit events in liquid funds, ultra short term funds (and even arbitrage funds). SEBI should have made the norms tighter in this section. Unfortunatley that is not the case.
It should have made a credit risk free short-duration category with only gilt funds. Instead, the current gilt fund category can invest in any gov bond ranging in duration from days to decades making it extremely difficult for investors who wish to minimise interest rate risk with no credit risk. In fact, about four short-term gilt funds changed colour thanks to this ruling: Death of a good mutual fund: DSP BlackRock Treasury Bill Fund
With the introduction of an exit load in liquid funds, it wants institutional investors to shift to overnight mutual funds from liquid funds. This will help retail investors. However, there is no credit quality restriction in overnight, liquid, ultra short term, low duration, money market, short duration, medium duration, medium-long, long and dynamic bond categories!!! This makes it not hard, but impossible for investors to choose funds other than stick to liquid funds (select ones at that) or gilt funds!
In fact, SEBI is more interested in supporting the bond market than help retail investors! In Dec 2017 (circular linked above), they made important modifications to their Oct 2017 circular:
Corporate Bond Funds
- Oct 2017: Corporate bond funds to invest 80% in only AA+ and above corporate bonds.
- Dec: 2017: They should invest predominantly in AA+ and above corporate bonds. No one knows how dominant is predominant – 50% or 60% or 75%! This exposes retail investors to higher credit risk.
Banking and PSU Funds
- Oct 2017 these funds should invest 80% in “debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds”
- Dec 2017 80% becomes “predominant”!!
They did the same with floating rate funds too, but 65% in Oct became predominant investments in “floating rate instruments (including fixed-rate instruments converted to floating rate exposures using swaps/ derivatives)”. I am not sure if this good or bad! Read more; How Floating Rate Debt Mutual Funds Reduce Interest Rate Risk
Impact on Hybrid funds
Arbitrage funds are worst affected with only 65% such exposure needed. The rest can be in any type of bonds, essentially killing pure arbitrage funds!
Equity savings funds have either no impact or have allowed them to invest in up to 65% direct equity, making them extremely dangerous especially with the “savings” tag. See this for example:
Thankfully not much change to aggressive hybrid, balanced advantage (dynamic asset allocation) and multi-asset funds (a welcome new category). The old monthly income plan (MIP) has now become conservative hybrid funds with 10-25% equity exposure.
Balanced hybrids with 40-60% equity (no arbitrage allowed!) fill a gap between aggressive hybrid and conservative hybrid in the risk ladder but is not practical use IMO and best avoided.
Summary
Although well-intentioned, the categorization and rationalization of mutual fund schemes by SEBI needs some tightening, especially in the debt space. Low duration gilts and low-risk options in liquid, money market, ultra-short and other categories will make the entire product universe a lot more attractive to investors who prefer guaranteed lower risk. What do you think about these changes? Have they helped you personally? Comment below.
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