SEBI’s Mutual Fund Scheme Categorization: Pros and Cons

Published: October 7, 2017 at 11:10 am

Last Updated on

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

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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  1. Dear Sir,

    Will this mean that HDFC prudence and balanced will have to be merged! That we would be a nightmare as AUM would cross 45 k crores..

  2. Sir, being a newbie, would like to know why this circular has come now? Was it a long due? What will be the next immediate steps for investors and AMCs?

    1. It was long due. You dont need to do anything. Your AMC might contact you in this regard. If you choose to stay invested, then there will no tax incidence or exit load.

  3. Thank you sir. If I understand this in a layman terms, it’s nothing but a declutter activity – to reduce several no of funds in the same category. With this investors will get a better clarity… Is my understanding correct?

  4. The part that you mentioned about hybrid funds is truly interesting. What is does is take away a lot of leeway from the fund manager and strictly have them stay in the narrow range of asset allocations once choosing to define the fund in a particular category. While definitions of Debt and Equity schemes are pretty well defined, the categorization of Hybrid schemes leaves the DIY investors wanting for more (or less).

    Question: Do you think investors choosing to dump their existing schemes, when the time comes, will create a short of short term impact on equities. Especially mid caps and debt schemes with less than 1 year maturity as that’s where the clutter seems to be the most. Of course, for a long term investor, this is all just noise in their larger investment journey.

    1. The classification is unnecessary but I dont think there will be any problems for AMCs wrt management. Of course they will have to merge schemes. My feeling is that SEBI will allow them to do this in a gated manner so as not to impact market price

  5. It feels like this is govt’s masterplan for more tax revenue if they force people to pay taxes in cases where funds get merged and they need to redeem and reinvest. Criminal lawyer knows plenty of money has entered MFs in the last year and large tax is to be collected. Funnily enough AMCs will find it hard to reclassify their funds under any of these categories because they may have invested in all kinds of caps and bonds

  6. In my opinion, it will definitely help the investor. The provision is “Only one scheme is allowed under each category”. But let’s take a case of HDFC balanced and HDFC prudence fund. Both the funds are managed by different fund managers and have their different styles. HDFC balanced maintains low risk profile when compared with HDFC prudence fund. So may be one investor who would like to take less risk or say comfortable with HDFC balanced fund and another who would like to take more risk and is comfortable with HDFC prudence fund. In case of merger any one of the investor will be in problem. He has to let go his own comfort zone and opt for another. What is the solution for this?

    1. Only HDFC can offer a solution here and I dont think it will be perfect. It is a pain for existing investor, but yes will help future investors.

  7. By creating a vague and incomplete classification, it looks like Sebi trying to wash their hands off. To what end, am not sure yet.

    Unless they create a broader classification, which specifies risk associated, underlying bond/equity ratio, and other parameters.

  8. If HDFC balanced & HDFC prudence get merged..either PJ or CS will have to loose their job..if not either of them ..than if both of them are having 10 team members each .. surely combining two schemes will not require 20 members… 12 to 15 shall do

  9. With regards to this announcement Is it better to wait and invest when the fund houses re-categorize according to SEBI regulation?. Im a newbie who is planning to start investing in MFs

  10. I’m retired and heavily invested in equity balanced funds with a monthly/quarterly dividend payouts to take advantage of equity taxation ,if held for a period of over a year or more.
    How will my taxation be effected in case of amalgamation or merger or discontinuation of some of the mfs on account of recatagorization?

  11. Half baked classifications. There should have been a second level of classification like aggressive, moderate and conservative based on market cap, value/growth etc in case of equity and interest rate/credit risk in case of debt.

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