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The Rationalization of Mutual Fund Schemes: Understanding the SEBI guidelines on categorization of mutual funds
May 25, 2018

Our note on SEBIs re-categorization of funds and the way forward for our investors.

Author : iFAST Research Team

Over the past couple of months, investors have seen a flurry of email messages from various fund houses as well as research teams like ours, informing them of name or attribute changes of almost all mutual funds in the industry. While there is a general understanding that this is in response to SEBI's circular from October 2017 that calls for re-categorization of open-ended mutual fund schemes, investors are largely confused about what, if anything, they need to do.

Our largest effort in this direction is our ongoing work on preparing the Research Desk's perspective on mutual fund categorization, after which we will be releasing our recommendations on the modified schemes. Until that is done, however, we would like to assure our investors that there is no cause for immediate or knee-jerk reactions. Much information is awaited on mutual fund schemes that are still being merged or modified. Any rebalancing of portfolios should only be undertaken after understanding exactly how the attributes of all the schemes under consideration have changed.

What's Going On

Not only is there no need for panicked reactions, investors can also be assured of this being a positive change. SEBI's objective in requiring re-categorization of mutual funds is to ensure that along with singing "Mutual Funds Sahi Hai", investors can also now hum "Mutual Funds Complicated Nahi Hai"!

Until the end of 2017, the classification of mutual fund schemes was a subjective call taken by research teams based on the Scheme Information Documents (SIDs). This could be at variance with the way the fund houses would classify their fund. Also, for each category of funds, a fund house could have more than one scheme. So when teams like ours would work on models to identify recommended funds, sometimes the top three funds in a particular category would belong to the same fund house. For example, in the large cap category, the top three funds could belong to the same fund house, having three different strategies: (I) investing into the top 50 stocks of the benchmark index; (II) investing into the next 50 stocks; and (III) investing into the top 100 stocks of the benchmark index.

Such a situation presents a dilemma for us as we are of the view that if we are recommending five large cap funds, they should all belong to different fund houses. These have been longstanding issues in the Indian mutual fund industry and the regulator has finally decided to uproot the problem.

A circular was issued in October 2017 wherein SEBI has specified the different categories of open-ended mutual funds, defined with strategies as well as the type of stocks or instruments across equity and debt funds. The biggest impact of such rationalization is that a fund house can now have only one fund in each category, with the exception of Index Funds or ETFs tracking different indices; Fund of Funds having different underlying schemes; and sectoral/thematic funds investing into different sectors or themes.

Broad Classification of Mutual Funds



What it means for you

The categorization and rationalization of mutual funds is expected to bring in a lot of transparency for investors. For research teams, recommendation becomes simpler as each fund house will present only one scheme per category – this also makes comparing category-wise performance between fund houses more straightforward. The uniformity in the scheme characteristics and the description of schemes also means that there is no longer scope for argument between fund houses and research teams on the appropriate category for a fund.

Some investors have been worried about the fact that the exit window option for a good number of funds is closed. Our advice, however, remains that being patient will be more beneficial right now. Our excel sheet, which tracks these changes, reveals that in a majority of the cases, we have maintained status quo on our recommendations.

Also, this whole exercise has to be seen from an overall portfolio point of view and should not be just fund specific. For example, our biggest bet in the large cap space, Aditya Birla Sun Life Frontline Equity Fund, continues to be a large cap fund. What has changed is the strategy - from a fund that used to be diversified across industries or sectors on its benchmark, the S&P BSE 200, it has now become a fund that is diversified across industries or sectors on Nifty 50. In effect, the fund is now more suitable for a conservative rather than aggressive risk profile.

Once you have assessed the change in a fund and whether or not it suits your profile any longer, you still need to identify the next best option from the recommended funds. With a majority of the funds undergoing a change in fundamental attributes, it would be advisable to wait until the categorization process is complete and all the funds in a particular category are in place. You would then be able to see the portfolios and historical performance of the funds, which will be very important in the case of mergers of schemes. A change in fundamental attributes implies that the investment strategy of the scheme has changed, and a closer look at the new portfolio will give you a fair understanding on the thought process of the fund management team as well, which ultimately is the deciding factor for the outperformance or underperformance of funds.

We leave you with the details on SEBI's classification of funds, and hope that you will keep accessing our excel sheet Decoding the Epoch: Research Desk's Perspective on Categorization.

Happy investing!

Disclaimer: iFAST and/or its content and research team's licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.

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