SEBI’s Mutual Fund Scheme Categorization: Pros and Cons

Published: October 7, 2017 at 11:10 am

Last Updated on October 8, 2023 at 1:48 pm

Yesterday, SEBI announced its new “Categorization and Rationalization of Mutual Fund Schemes”. In this post, I discuss the positive and negative aspects of this move. As with any change, it is a mixed bag, especially for existing investors.

SEBI has made it clear that only one scheme per category will be allowed and that AMCs will have to align their existing fund bouquet with the new classification. This could mean merger, closure or “change in fundamental attribute” of several funds. When this happens, the fund house will offer investors to exit without load during a specified period. The necessary tax on such an exit will have to be borne by the investors. If a scheme merges with another and the investor continues to hold units, no tax need be paid.

Since many fund houses have well-established funds (plural) in each category, it not clear which ones will be merged. I would prefer to invest normally, cross that bridge when we come to it and not worry about it now.

This is the SEBI circular

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SEBI’s Mutual Fund Scheme Categorization: Positive aspects

No classification scheme is perfect and as long as fund houses respect it, I see this as a step in the right direction. I also expect reasonable conformity with this categorization scheme in about six months. All stat rating portals will be forced to fall in line with this and the quality of the peer comparison should only become better (that does not make it useful, but at least less wrong).

Regular readers may be aware that I have long spoken about the need for a proper debt fund classification. Earlier only liquid funds had a clear mandate of investing in bonds up to 91-day duration. The new debt fund classification (see below) should help investors choose to some extent.

SEBI’s Mutual Fund Scheme Categorization: caveats

This is a big shakeup and will take time for the AMCs to take it all in, reclassify their existing schemes, appeal to SEBI (if needed) and then write to investors about it. So it will be a period of uncertainty for existing investors, but no point worrying about it. As with any big change, short-term pain is the price to pay for long-term benefits.

Only one scheme per category would be permitted

This is a positive for new investors and pain for old investors!!

The problem is that investors who wish to exit a scheme that has changed mandate or has merged, will have to pay tax because of this SEBI ruling!

While the new scheme classification will help new investors find a reasonably suitable space in the real estate universe, experienced investors will agree that this is only a compass with just four directions marked and more understanding is necessary to select product categories (forget funds). Choosing a mutual fund is not as important as selecting suitable fund categories. My point is that investors should not blindly assume a fund placed in a particular category actually behaves as mentioned in the category label. It is only a broad classification.

All our regulators are living and learning (often at our cost) and this move (which is about 20 years late) is no different. Just because it is from “SEBI” does not make it “right”. It is merely an attempt to make sense of the mutual fund jungle. It is a good move, but should not be taken at face value.

This circular applies only to open-ended funds. Why not closed-ended funds?!!

SEBI’s Mutual Fund Scheme Categorization: Equity funds

The basic large-cap, mid-cap and small-cap funds have a clear definition and this is easy for investors to construct a diversified portfolio. However other categories and shown in the slide below are not well defined.

SEBI's Mutual Fund Scheme Categorization Equity funds

SEBI’s Mutual Fund Scheme Categorization: Debt Funds

Debt funds will have to classified on how volatile their NAV is to interest rate movements. The modified duration is a commonly used measure. SEBI has chosen a variant the Macaulay duration. This will not take into account changes in yield to maturity. I would recommend using modified duration for identifying rate risk.

SEBI's Mutual Fund Scheme Categorization: Debt Funds one

SEBI has made an effort to segregate credit risk by differentiating corporate bond and credit risk funds. However, gilt category does not have any restriction on duration and this can be painful for investors who wish to avoid credit risk completely and also minimise rate risk.

SEBI's Mutual Fund Scheme Categorization: Debt Funds two

SEBI’s Mutual Fund Scheme Categorization: Hybrid Funds

This is probably where things get most confusing! I think this section is a bit of an overkill. If you hold a hybrid scheme, can you spot your fund category?

SEBI's Mutual Fund Scheme Categorization: Hydbrid Funds

Overall, SEBI has done a reasonable job, but conforming with it will be a huge pain for AMCs and therefore investors. On the bright side, this is a good news for a new DIY investor.

Over to you. What do you think?

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