Fund reclassification: Why did it happen?

Given that the mutual fund industry was sailing along smoothly and attracting record inflows, why did SEBI initiate this reclassification exercise? That's a question which has been asked often in recent months. The answer is that it was a well-intentioned attempt to address three issues that have historically plagued Indian mutual fund investors - the lack of simplicity, standardisation and truth in labelling of mutual funds.

Too much choice: Thanks to their penchant for launching NFOs at the drop of a hat, Indian AMCs have accumulated far too many schemes on their menu over the years. The innumerable mergers and acquisitions in the industry have added to the clutter, with the acquiring fund houses often reluctant to merge or wind up schemes, thus ending up with multiple schemes with similar mandates and portfolios. At the end of October 2017, when SEBI announced its new rules, the 41 AMCs managed 830 open-end schemes, 1,060 closed-end schemes and 43 interval funds between them. Given that retail investors, at best, need only four to six funds to build a decent portfolio, these schemes - with their plethora of plans, options and sub-plans - made for a befuddling array of choices for investors. Newbie investors attempting to choose funds were often put off by the sheer complexity of choices they had to make.

Vague mandates: Investors who tried to wade through the confusion by bucketing schemes into categories were led astray by the lack of standardisation in mutual fund categories. In equity funds, for instance, one AMC's definition of 'large-cap fund' would be to stick to the top 100 stocks but another one would swear by the top 200. Some mid-cap funds would invest exclusively in the constituents of the BSE or NSE mid-cap indices, but others would freely roam the entire universe beyond the top 100 stocks. In debt funds, one short-term fund would invest only in AAA bonds while another would take on considerable credit risks. Loose category definitions made scheme comparisons quite difficult. Category 'drift' was common, with schemes often segueing from one category to another based on the market mood.

Misleading labels: When selecting their schemes, investors couldn't be sure that the scheme delivered what it promised on its label. Mutual fund portfolios and strategies in many cases did not reflect the scheme name. Thus, 'blue-chip' funds would dabble in mid-cap stocks, 'growth' funds would adhere to value investing and 'balanced' funds would go all out on equity exposures. In the debt category, there were no clear boundaries on duration or credit risk. Sometimes, investors choosing a scheme based on its current portfolio would find that it had morphed into an entirely different animal over time.

SEBI's fixes
SEBI's circular in October 2017 on categorisation and rationalisation of mutual fund schemes addressed these issues through three sets of measures.
Standard categories: To standardise the types of schemes that AMCs could offer, SEBI laid down five key groups into which all fund houses would have to fit their existing and new schemes - equity, debt, hybrid, solution-oriented, and others (consisting of fund of funds and index products). It also laid down the types of schemes that can be offered within each group. So, post-SEBI rejig, there can only be 10 types of equity funds, 16 types of debt funds and six types of hybrid funds. In all, every AMC can offer a total of 36 types of schemes across asset classes.

Only one per category: To ensure that fund houses didn't run duplicate schemes with similar objectives or portfolios, SEBI has made it mandatory for every AMC to offer only one scheme under each of the 36 categories allowed by it. There are a couple of exceptions to this rule. AMCs could still offer multiple sector/thematic schemes playing on different sectors or themes and they can offer multiple index products mirroring different indices. But broadly, fund houses that managed multiple schemes with similar mandates had to merge them or wind them down to comply with the one-scheme-per-category rule.

Truthful labels: To ensure that mutual funds delivered what they promised, SEBI has laid down precise definitions of what constitutes each fund type. For instance, the confusion over market caps has been cleared by defining the top 100 stocks in the market as 'large cap', the next 150 as 'mid cap' and the rest of the listed universe as 'small cap'. The list of approved large-, mid- and small-cap stocks will be published every six months by the industry body AMFI. Fund managers can henceforth pick their stocks only from this universe. SEBI has also mandated that large-cap funds have to own a minimum 80 per cent exposure to large-cap stocks. Mid-cap and small-cap funds have to have a minimum 65 per cent exposure to these stocks. In the debt category, schemes have to adhere to specific duration limits to label themselves as low, short, medium or long duration.

Announcing these new norms in October 2017, SEBI offered all AMCs two months' time to come back with a rejig plan for all their schemes. Once these were approved by SEBI, mutual funds were allowed to issue addendums in newspapers (and on their websites) and go ahead with the changes. Where schemes made significant mandate changes (change in fundamental attribute) or were merged, they were required to go back to their existing investors to give them an exit option without any load (charges). In other cases, schemes could go on with business as usual after informing investors of the changes.

What's the result?
The new categorisation norms have forced the 41 AMCs to review all their open-end schemes and to come up with a comprehensive plan to rationalise them. Broadly, they have attempted to fit their existing schemes into one of the 36 categories, merge duplicate schemes into a single one, and precisely define and re-align all scheme mandates. For most fund houses, the changes take effect between March and June 2018.

Broadly, fund houses have fallen in line with SEBI norms through four kinds of changes to their existing schemes - changes in scheme name or type, changes to fundamental attributes and mergers between schemes. While changes in scheme name or type are cosmetic changes not requiring any action by investors, investors need to take note of any fundamental attribute change to their holdings. To assess if a scheme is changing materially, pay attention to four aspects - its new category, new asset-allocation pattern, benchmark and objective. If these four aspects have registered significant changes, reassess the scheme afresh to see if it fits with your risk profile and portfolio objectives. Scheme mergers may or may not result in fundamental-attribute changes but can be reviewed on similar lines.

Overall, SEBI's mutual fund rejig is likely to deliver more standardised and truthfully labelled mutual fund schemes to investors. But the one aspect on which it hasn't succeeded is to simplify their choices.

At the end of April, the number of open-end schemes managed by the 41 AMCs still stood at 840 schemes, slightly higher than the number in October, when SEBI mooted this rejig. While the data at the end of May could show some shrinkage in these numbers, it is unlikely that the menu has contracted a lot as most AMCs have tried their level best to retain their existing schemes in one form or another.

Also note that the SEBI norms don't apply to closed-end schemes. With AMCs continuing to roll out closed-end NFOs, that list is likely to keep expanding.

However, investors need not be too put-off by all this. Even if AMCs refuse to simplify their menus, investors can certainly keep their mutual fund diet simple by sticking to a few well-chosen schemes in the must-have categories.