The regulator had been long considering categorization and rationalization of mutual fund schemes. The reason was quite simple. A large AMC would typically have 4-5 diversified equity funds with different names. This became a source of confusion for the investors as they could not understand the differentiation between the schemes and therefore the choice became a lot more difficult. Let us first understand the premises on which the SEBI mutual fund categorization circular was passed late last year.

 

Recent SEBI guidelines for mutual funds reclassification

Naming of the fund should be based on the core intent of the fund and asset mix of the fund. The name should reflect the asset mix and the risk of the asset mix clearly.

SEBI reclassification of large cap, mid cap and small stocks based on market cap relative rankings rather than based on absolute market cap cut-offs.

SEBI has prescribed  10 classifications for equity funds, 16 for debt funds, 6 for hybrid and 2 each for Solution Funds and Index Funds

Except index funds, all the other category can only have 1 fund per classification. That means an AMC can only have a maximum of 34 funds outside of index funds.

While equity exposure is the key driving force for equity fund classification, the debt fund classification is based on duration of the fund and the asset quality mix

1.  Equity Funds can have a total of 10 classifications. Of these 10 categories, 5 will be purely based on market capitalization. Here SEBI has clearly defined that the top-100 ranked by market cap will be large cap; 101-250 ranked by market cap will be mid-caps and 251 ranks onwards will be small caps. In addition, SEBI has also permitted additional categories like value fund, contra fund, sector fund, thematic fund and dividend yield fund. The AMC can have just 1 fund under each of these 10 equity categories.

2.  Debt Funds will have a total of 16 classifications and the classification will be based on duration of the fund and the credit quality. There will be a total of 10 funds based on duration ranging from overnight funds to long duration funds. The remaining 6 categories are based on credit quality and will range from credit risk fund to a risk-free gilt fund. Here again, an AMC can only have 1 fund under each of the 16 categories.

3.  Hybrid Funds will have a total of 6 categories and will include arbitrage fund and MIPs under it. The remaining categories will be balanced funds based on their conservatism and whether the asset allocation is dynamic or static. An AMC can have only 1 hybrid fund under each of these 6 categories.

4.  Solution Oriented Funds are those that actually offer a readymade solution to meet your long term goals. SEBI has permitted 2 categories under this head and an AMC can have a Retirement Fund and a Children’s Planning Fund in its portfolio.
 

5.  Other Funds are those that do not fall into the above four categories. These will include index funds, ETFs and Fund of Funds (FOFs). The advantage here is that you are not limited by the restriction of 1 fund per category only. Thus the AMC can have an index fund on the Nifty; index fund on the Sensex and also on the Bank Nifty.

 

What will this reclassification of mutual funds achieve?
While these are essentially early days, there are 5 distinct outcomes that one can expect from this move:

There will be greater clarity as far as the investors are concerned. Since the fund classification is based on the end use of the funds and the asset quality, this is the right step in terms of MF simplification for customers.

There could be a merger of schemes. For example, if the AMC has 3 equity schemes in the same category then under the new rules, there will be only 1 scheme. Every new scheme floated by the AMC must have a unique value proposition to offer to investors.

The exercise may result in some interesting reclassification. For example, if the portfolio of the particular equity scheme is invested 96% in the Nifty stocks then it would require reclassification as an index funds and will entail lower costs.

As funds get bigger their average expense ratio loading on the clients will reduce. This will ensure that the net impact on the investors is much lower and therefore their net returns are actually much higher.

There is only one challenge in this entire exercise. Merger of schemes could create uneconomically large sized funds. This is truer of mid-cap funds where the investment opportunities in the market are limited. Merging 3 mid-cap funds with AUM of Rs.3000 crore into a single fund with AUM of Rs.9000 crore could make it unwieldy. That will be a challenge for the fund manager.

Overall, the SEBI move to reclassify mutual funds is a step in the right direction. It compels fund managers to actually provide a clear value proposition to the investors. That could be the big take-away!