What SEBI’s circular on scheme category definitions implies

For all open-ended schemes, SEBI has issued a circular that defines the characteristics of each mutual fund category across equity, debt, and hybrid schemes. Following is the background leading up to SEBI’s decision, the circular’s proposals, and the impact on investors.

Background

The number of open-ended funds has been rising over the years, as investor interest picked up and AMCs sought to increase options for investors. This led to an increase in the number of funds offered by each AMC. This led to the following issues:

To which category does the fund belong? Each fund needs to be bucketed into a particular category – that is, equity large-cap, equity mid-cap, equity multi-cap, liquid, ultra short-term debt, short-term debt, equity-oriented hybrid, debt-oriented hybrid, and so on. But there was no clear or single definition for a large-cap stock or a mid-cap stock or a small-cap stock. Consequently, there was also no definition of a large-cap fund, or a multi-cap fund, or a mid-cap fund and so on. Similarly, there was no definition of high credit risk or low credit risk, no clear distinction between the various types of hybrid funds and so on. Each AMC – and analysts and rating agencies such as Value Research or FundsIndia’s own research – had their own definitions.

What is the difference between each fund? Funds follow a specific strategy to manage their portfolios. However, with a single AMC having several funds, this strategy clarity and the differences between each scheme was usually unclear. Some AMCs had portfolios that were very similar. Many funds also tended to change strategies depending on the market and thus the fund’s category also was apt to change. AMCs acquiring other AMCs also led to duplicity of funds.

This meant that there was no uniformity in category definitions. Therefore, comparison of funds became difficult for retail investors especially in the light of several hundred funds.

SEBI’s proposals

In order to address this issue, SEBI has defined both stock market capitalisations and fund categories. These proposals apply to only open-ended funds and not close-ended funds. Broadly, there are five main fund types and sub-categories within each, as follows

Each category is now defined by SEBI. For example, a large-cap equity fund should have 80% of its portfolio in large-cap stocks. A small-cap fund should have 65% of its portfolio in small-cap stocks. A corporate bond fund should have at least 80% in highest-rated corporate debt. You can refer to the circular for the full list of definitions of each category and stock market capitalisations.

Importantly, each AMC can have only one fund in each category – except index funds/ ETFs, Fund-of-funds, sector, and thematic funds where they can have as many as they wish.

What’s the impact?

AMCs have 2 months to fit their funds into each of these categories. It will involve working out which schemes to merge and which to retain, the strategy to follow, and adapting the portfolio in order to comply with the rules. AMCs need to submit this rationalisation of their schemes to SEBI, which will vet and approve of the changes. Once this approval is done, AMCs have 3 months to complete the realignment.

For you, this is what it means:

• Funds you hold may be merged with others. This is especially true if those funds have very small AUMs or have significant portfolio overlaps with other funds. AMCs with a large number of funds, such as ICICI, Aditya Birla Sun Life, Reliance, HDFC, SBI, and Franklin Templeton can see more such mergers.
• Funds may see a change in their strategy, orientation, and therefore their risk profile. Where it results in a fundamental attribute change, you may have the option to exit without load. Even so, such a change also changes a fund’s suitability for your purpose.
• Fund NAVs may see some volatility in the coming months as they rework their strategy and portfolio to fit the category definitions.

Apart from this, AMCs, mutual fund data providers, and mutual fund research will have uniform categories and funds within each category. This rationalisation will come about once AMCs are done with their own rationalisation. New fund offers may dry up for the next 6-8 months, unless they are index funds or ETFs. At the end of this exercise, the total number of funds available for investment will shrink drastically.

SEBI’s proposals involve a complete overhaul of fund strategies and categories. It is a complicated and massive task for AMCs to rework their funds to fit the new proposals. SEBI approvals may also be protracted and long-drawn especially since it will be faced with a flood of approval requests by all AMCs. Put together, this means that the merger and rationalisation process will take several months. Only then will you be notified of changes. Once this begins, we will have clarity on what funds will sustain and the manner in which they will be managed. The course of action, at that point, will depend on the scheme into which mergers will be done or the fund strategy and category, and whether the new funds suit your requirements.

In the near term, no immediate action is required on your part. Continue with your investments and SIPs. It’s best not to worry or panic about changes in the absence of any clarity. FundsIndia investors can get in touch with us at any time. We are always available towards helping you deal with fund mergers, changes in strategy and their suitability for your purposes. We will also appraise you of changes and their impact when they take place, and as clarity emerges on the characteristics of each category.