Why SEBI introduced the new Mutual Fund Categorization

Like any mutual fund investors, you must have worried about the 20 different equity schemes that a single AMC offers. If you scratch the surface, the almost have a similar portfolio profile. The big challenge is how do you as a mutual fund investor make a choice? You are obviously confused. Firstly, there are over 40 AMCs and each AMC has over 50 schemes. Within each scheme, there are dividend plans and growth plans. Then you can also opt for a Direct Plan versus a regular plan. You may be spoilt for choice but you are surely confused with this surfeit of fund options. That is why SEBI announced its new norms for fund categorization.

The new fund categorization norms are based on two principal ideas. Firstly, an AMC should be permitted to have only one fund per identified category. Secondly, the name of the fund should reflect the objective of the fund. That is only possible through standardization. These two were the core goals of the MF categorization. In the process, it will make the task of financial advisors much simpler.

Mutual Fund Investment 1 Why SEBI introduced the new Mutual Fund Categorization

Key highlights of the new fund categorization norms

  • SEBI stipulates that naming of the fund should be essentially based on the core intent of the fund and its asset mix. The name should reflect the risk clearly.
  • It has reclassified the definition of large cap, mid cap and small stocks based on market cap relative rankings rather than based on absolute market cap cut-offs. Now all funds have to follow this benchmark only.
  • SEBI has prescribed 10 classifications for equity funds, 16 for debt funds, 6 for hybrid and 2 each for Solution Funds and Index Funds. That still looks quite high but it is good as a starting point.
  • There is an exception made for index funds. All the other categories can only have 1 fund per classification. That means an AMC can only have a maximum of 34 funds outside of index funds.
  • Equity fund classification will be based on equity exposure while the debt fund classification is based on the duration of the fund and the asset quality mix.

Five levels of mutual fund categorization by SEBI

  • Equity Funds are permitted to 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 a large cap; 101-250 ranked by market cap will be mid-caps and 251 ranks onwards will be small caps. SEBI has permitted additional categories like value fund, contra fund, a sector fund, thematic fund, and dividend yield fund. The AMC can have just 1 fund under each of these 10 equity categories. But the criteria will remain standard across all the AMCs.
  • Debt / Income Funds can have a total of 16 classifications which will be based on the 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. You start with liquid funds at the short end of the curve and go to long ended bonds. The remaining 6 categories are based on credit quality and credit risk and will range from credit opportunities fund to a risk-free gilt fund. Here again, an AMC can only have 1 fund under each of the 16 categories.
  • Hybrid Funds will have a total of 6 categories. Fortunately, SEBI has rationalized this system and included MIPs and arbitrage funds also under this category. The categories will be balanced funds based on their conservatism and whether the asset allocation is dynamic or static. A dynamic allocation fund is where the fund manager has the discretion to shift allocations between debt and equity on an active basis. An AMC can have only 1 hybrid fund under each of these 6 categories.
  • Solution Oriented Funds These are funds that directly provide a long term financial solution to investors so that they don’t have to go through the hassle of planning for it. Here there will be two categories; Retirement Fund and a Children’s Planning Fund.
  • Miscellaneous Funds are those that do not fall into the above four categories. These will include index funds, ETFs and Fund of Funds (FOFs). The merit here is that you do not have the restriction of 1 fund per category only.

What will SEBI and investors achieve through this classification of mutual funds?

There could be 5 distinct implications from this move:

  • Investor confusion will surely reduce and fund choice according to the objective will become easier. Since the fund classification is based on the end use of the funds and the asset quality, the approach to funding nomenclature is a lot more scientific.
  • 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. Funds cannot change the name and objective for the heck of it. It has to be well thought through.
  • Some interesting reclassifications may emerge. If the portfolio of the particular equity scheme is invested 90% in the Nifty stocks then it would require reclassification as an index fund and will entail lower costs.
  • The categorization will lead to consolidation of funds in many cases. As funds get bigger their TER 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 could be one hassle. Merger of schemes could create uneconomically large sized funds. Merging 3 mid-cap funds with AUM of Rs.2500 crore into a single fund with AUM of Rs.7500 crore could make it unwieldy. Already, many mid cap funds are shutting their fund to new subscribers as there are no opportunities available in mid caps. This could only accentuate the problem.

The reclassification of mutual funds is a step in the right direction. It compels fund managers to go beyond mere semantics and actually offer a value proposition to the customers. As for investors, the selection becomes easier. Above all, advisors will breathe a sigh of relief for the simplicity that this move will catalyze.

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