FundsIndia Views: SEBI’s new categories – what’s changing in your equity funds

A month ago, we wrote about what SEBI’s scheme re-categorization means for you. Now, with a good chunk of the changes announced by AMCs, we’d like to get into what the changes broadly are with examples and let you know what you should watch out for and what you can ignore.

This week, we’ll discuss about equity and hybrid balanced categories and next week we’ll look at debt and debt-oriented hybrid categories.

How they realign

When fund houses mapped their current funds to the new categories, one of the following happened:

• A fund could fit into a category neatly without calling for any change. In these cases, just a category change and sometimes a name change was required. In some cases there was no change at all. For example, a Franklin India Bluechip fitting into the largecap category or ICICI Pru Value Discovery being classified as a value fund required no change. There was no exit period since no fundamental attributes changed. As of the first week of May, about 50% of the over 400 funds (compiled from addendums) in equity and hybrid categories came under this.
• A fund may have been given an exit period by the AMC due to changes in its attributes. This could have been done for two reasons: one, there would have been a small change in the scheme information document (SID) although nothing in terms of strategy changes. For example, Kotak Balance will remain a balanced fund (called aggressive hybrid). Since the new category allows it to go up to 80% into equities a change in its SID was warranted. This required providing an exit period. Two, there could have been a change in strategy itself. For example, Aditya Birla Sun life Top 100 becoming a focused fund is change in strategy although not very significant. On the other hand, SBI Magnum Equity shifting into a thematic fund is significant. Overall, about 50% of the about 400 funds had/have an exit period. Of this, just 12 founds saw a merger. Of the funds with an exit period, a good 20% or 1 in 5 funds, saw a ‘significant change’ that requires watch.

What is a significant change

We have discussed in our earlier article that a change, in our opinion, is significant only in the following cases for equity funds:

• The fund must meaningfully increase or decrease large/midcap/small-cap stocks in order to comply with the norms laid out in the new category
• The fund must change its asset allocation (in equity/debt/gold) or bring in derivatives
• The fund must reduce the number of stocks it holds (focused)
• The fund must change its strategy in terms of picking stocks (example: contra, value, dividend yield) or in terms of concentrated sector exposures
• The fund becomes a thematic fund

Since all the above can change the risk-return equation of a fund, we consider them significant.

Now, let’s get into the various categories into which funds were classified earlier to see where changes are significant. The categories we mention here as sub-heads are all ‘old categories’ thus far used by FundsIndia based on earlier market-cap segments. We will be transitioning to the new categories once all the changes are done.

Large-cap funds

SEBI requires this category of funds to hold at least 80% in large-cap stocks. Large-cap is defined as the first 100 stocks in terms of market cap.

A little over 40% of the large-cap funds for which we have data have remained in the large-cap category. A few have categorized themselves as focused (which they already were) and the rest in large & midcap/multi-cap/contra.

The ones that have moved to different categories have lesser restrictions in their investment universe. For example, Invesco India Growth and ICICI Pru Top 100 are moving to the large and mid-cap segment. That means they will have more leeway to invest in midcaps. Hence, while risk may go up a bit, their return potential too can be expected to increase, subject to good performance. On the other hand, a Reliance large cap (earlier called Reliance Top 200) which had an average 70% in large caps 9as defined by SEBI) will have to now hold at least 80% in large-cap stocks. Thus, the new norm becomes marginally more restrictive for the fund.

The table below summarises our take on this:

What we will watch for: Our task, where funds remain in the large-cap category, would be to see if return potential is diminished. This is because of the definition of large-cap by SEBI. Currently the 100^th stock is a little over Rs 29,000 crore in marketcap. Earlier funds defined even a stock with Rs 25,000 marketcap as largecap. By way of SEBI’s definition, the universe of investible stocks has shrunk.  We will watch to see whether fund managers are able to keep up performance by active stock/sector exposure compared with benchmark, or by using the small leeway they have to invest in stocks other than large-cap stocks.

Diversified/multi-cap funds

About a third of the funds have been categorized as large & midcap or multi-cap. The others have gone into value/contra/dividend yield. In our opinion, there is not much distinction between the two. Having said that, large and midcap as a category is required to hold at least 35% in large caps and at least 35% in midcaps. No such restriction exists with multi-caps. A few funds such as Franklin India Flexicap or DSP BR Equity Opportunities though, will start holding higher midcaps as a result. Others such as SBI Magnum Multiplier would not need any such tweak.

What we will watch for: We will not be worried about any significant change in performance in these funds as they have a higher flexibility in stock and marketcap allocations. But comparing these funds with new peers entering the category is a different challenge to tackle. We will discuss this later. What we will caution you about is to avoid comparing peers in the new large & midcap, value, or multi-cap category for some time. These peers come from different market-cap segments and have different historical performance which is not comparable.

Midcap funds

SEBI requires a mid-cap fund to hold at least 65% of its assets in mid-cap stocks. Midcap is defined as the 101^st to 250^th stock in terms of marketcap.  A little over 40% of the midcap funds in our compilation have remained midcaps. The others have moved to large and midcap/multicap/smallcap/focused and so on. The prominent ones to move to large and mid-cap category would be Mirae Asset Emerging Bluechip, Principal Emerging Bluechip and Canara Robeco Emerging Equities. Invesco India Mid N Small Cap fund would become a multi-cap fund, which means it need not do anything but can also do anything!

What we will watch for: In this category, again, we are not too worried about funds that shifted to large & midcap or multicap. For example, the Mirae fund always had about 35% in large-cap and will require only that level of holding to qualify into large & midcap. We will however be concerned about two issues: first, the restriction in terms of market-cap for midcap funds, as defined by SEBI. The 101^st to 250^th stock in terms of market capitalization is considered as midcap.

The universe of 101^st to 250^th stock means, at present, stocks between Rs 8,500 crore and Rs 29,000 crore would only be midcap stocks. However, earlier even a Rs 5,000 crore stock would have qualified as midcap in most funds’ portfolios. We hope funds make use of the leeway provided (at least 65% should be in midcap stocks and rest can be invested anywhere) to invest in small-cap stocks too to maintain performance. We will hence keenly watch for performance on this front.

Our second concern would be about the present midcap funds moving into large & midcap or multicap and dominating this category because of aggressive past performance. For example, a star midcap performer like Mirae Asset Emerging Bluechip would be placed in the same bucket as DSP BR Equity Opportunities (which has a predominant large-cap history) and Aditya Birla Sunlife Advantage.

What hasn’t changed much

The following categories have not seen too many funds shift out. Even if they did, the changes are not significant.

What you should do

• If funds that you hold fall under the old large-cap or mid-cap category and continue to stay there, you can check with your advisor a year from now on how these funds are faring.
• If you hold large-cap or midcap funds which have shifted categories now, check whether your allocation needs to be changed to maintain your originally intended allocation. However, it will take us at least 1 quarter to assess how the fund portfolio has changed to adapt to its new category. Hence, get this review after September 2018. One tip here: if you have a large-cap fund that has shifted to other categories, do not consider upping large-cap exposure. It is perfectly fine to be holding a large & midcap or a multicap fund so long as their large-cap holding is higher than their midcap holding.
• If you held a diversified/multi-cap fund, you don’t need to act as there is unlikely to be any significant impact.
• You can continue your SIPs and investments in your funds unless you hear from research & advisory on why you should move out of a fund to another.

What you need to avoid

As mentioned earlier, avoid doing peer comparison for at least 3-4 quarters, specifically in segments where funds have come from different categories. Large & midcap and multicap categories are key categories where the return differential between funds will be wide given their historical portfolio and marketcap orientations.

For example, comparing a large & midcap fund that moved from midcap with another large & midcap fund that moved from either large or diversified would clearly put the erstwhile midcap fund in an advantageous position. Such anomalies are best avoided.

We will be normalizing past performance of funds that have shifted from different categories to ensure we do not compare a high past performer from an aggressive category with a regular performer from a sedate category. As always, rest assured that FundsIndia’s research will keep watch over the strategy changes and the consequent performance change, if any. We have always gone beyond merely looking at returns into looking at portfolio quality and strategy. We will continue to do so with heightened vigilance now.

With LTCG tax also introduced, we would want to avoid unnecessary churn to your portfolio. If an exit or change is recommended, we will do it after giving the fund manager a chance to rejig, settle and perform. Please note that this SEBI categorization is easier on paper but requires a lot of work from the fund house.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.