In the three weeks since SEBI released its circular on categorization and rationalization of mutual fund schemes, there have been at least two dozen opinion pieces written on it, across newspapers, blogs, and online portals. With a number like that, it is usually pointless to try and add anything new to the conversation. But after going through what has been written, and speaking with advisors and investors, I feel that SEBI’s circular hasn’t been appreciated as much as it should have. I think it is one of the most important directives from the regulator in recent times, and deserves a standing ovation. If nothing else, I’d like to add my voice to that of those who have applauded it.
Here are some of the ways in which I expect it to benefit investors:
You’ll know what you’re buying: A number of fund houses have made it difficult for investors to comprehend the true nature of the schemes that they buy into. In some cases, the scheme names are misleading while in others, the investment objectives are way too ambiguous. While the issues with the names may still persist, SEBI’s elaborate description of most categories leaves little wriggle room for fund houses to creatively expand a scheme’s investment objective. So once this directive comes into effect, if you buy an equity scheme categorized as ‘large cap’, you’ll know exactly what to expect.
You’ll have clearer choices: Currently, choosing between scheme categories can be tricky. There are at least two issues that investors face. The first is that there is a lack of uniformity in the way that scheme categories are defined by various entities. For example, one prominent online portal divides domestic, diversified, non-ELSS equity funds into five categories whereas another splits these into just three categories. Hopefully, SEBI’s intervention into the classification process will result in all these entities adopting a uniform approach.
The second problem is that among the prevailing classifications, some categories are so loosely defined that certain schemes could fit into any of two or three different categories. As a result, there are differences in the way that these schemes are categorized by different entities. While SEBI’s classification does not completely eliminate overlap, the important difference is that there will now be little ground for an entity to categorize a scheme any differently from the way a fund house does.
As a foot note, I’d like to say that I disagree with those who contend that the SEBI circular keeps far too many categories, particularly among debt funds. I believe that the number of categories is a less consequential issue than it is being made out to be. As for debt funds, their structural complexity as well as the widely segmented audience that they cater to, necessitates far many more categories than equity funds. I think that the categories put forth by SEBI meet that requirement quite well.
Underperformance will be difficult to mask: At present, some fund houses have multiple schemes with similar objectives but with subtly different strategies/ portfolios. This enables them to hedge their bets on which strategy/ portfolio will do better. But more than that, this helps in effecting a psychological deception upon prospective investors. Put differently, if you are a prospective investor who is comparing fund performances in a category in which there are, say, two somewhat similar schemes from the same fund house, you are more likely to notice the better performing scheme (and miss seeing the underperforming scheme). Thanks to SEBI’s stipulation that a fund house can have only one scheme in most categories, fund houses will now have to necessarily go with their highest-conviction strategies. Hopefully, then, a clearer picture of the true performance of a fund manager should emerge.
Style drift will be curbed: Style drift is far more widespread than most people realize, and is thus a bigger risk than most people realize. Going by the latest SPIVA India scorecard, as many as 53% of the funds that were classified by Morningstar as large-cap 3 years ago (and which continue to exist today), no longer have a large-cap orientation. In fact, in just the last 1 year, 25% of equity funds that were classified as large-cap, have ceased to have a large-cap orientation. In case you’re wondering, it isn’t just large-cap funds, or even equity funds. 11% of equity funds that were classified as mid/small-cap a year ago, are no longer classified as such, while 32% of debt funds across Morningstar’s ‘Intermediate Bond’ and ‘Short-Term Bond’ categories no longer fit those categories. SEBI’s circular is short on the details of how it will monitor style drift. But the painstaking detail in which it has defined most categories, gives one the confidence that that, in itself, should be useful in curbing style drift, without constraining a fund manager’s flexibility.
You’ll be able to make fair comparisons: Making fair and accurate performance comparisons between schemes is integral to good investing. Unfortunately, on account of the issues mentioned earlier (ambiguous investment objectives, style drift etc.), investors are rarely able to do so. Once SEBI’s classification comes into effect, this should become a thing of the past, and you should be able to make genuine apples-to-apples comparisons of fund performance. Doubtless, it will take time for the benefits to materialize but from the point of view of investors, this could well be the biggest benefit from SEBI’s directive.
