India’s mutual fund regular, the Securities and Exchange Board of India, or SEBI, recently announced a sweeping change in the manner in which mutual funds are to be categorized.
While markets such as U.K., Canada and Thailand have had fund categories defined by the industry body, this move is historic in the sense of being the first attempt globally by a fund regulator to set defined categories and respective mandates.
The timing is impeccable too; just as the Indian mutual fund industry is at the cusp of breakout growth.
Our stance in a nutshell…
Globally, Morningstar has been categorising funds for over three decades and we have a fair grasp of the difficulties and nuances involved.
We do believe that this is a pro-investor move as it clearly defines the mandate for fund categories, which aids investors in identifying and comparing suitable investments with similar mandates.
While we salute the regulator’s attempt to curb product proliferation by companies within a given category, we have taken cognizance of the blurred lines between some of the categories.
Moreover, the dictum for a fund company to include only one scheme in each category is fairly restrictive, specially where clear style differences can co-exist between funds of a similar category.
Finally, the introduction of new categories increases the choice which leads to an additional dilemma of choosing the most suitable fund category.
Categories
There are 5 broad fund types and total of 36 fund categories; too many in our opinion.
The defined investment mandates for each fund category make it easier for an investor to compare funds and pick the right one from a homogenous set. This was a much harder task earlier as the mandates were fairly broad.
The trick is identifying the ideal fund category for one’s portfolio given the increase in number. Applying a one fund rule though does put additional pressures on the categorisation system and the exceptions. Allowing 2 to 3 funds per category would have removed some of this pressure.
The exceptions for indexing and fund of funds (FoF) addresses two obvious areas where a fund company would have multiple funds in the category. The last exception for “sectoral/thematic funds”, will depend greatly on interpretation of what is an identifiable ‘theme’.
Also, a defined number of categories can potentially limit product innovation. It will be interesting to observe how the regulator will view proposals for suitable new fund categories if and when they arise.
Impact on existing funds
There are expected to be some mergers between schemes as asset managers seek to limit the schemes to one fund per category and realign them as per the defined mandates. Concerning the latter, the number of categories does provide sufficient headroom to do so. In fact, some may even exercise the option to launch new funds if they deem fit.
Morningstar conducted an analysis of the existing open-ended funds. Of the 800+ open ended funds, we expect the number of funds post realignment to be in the ballpark of 700, which is a 10-15% reduction in the number of schemes. The bigger asset managers will be the most affected, especially those who have had bought out or taken over schemes of other AMCs which resulted in the number of schemes bloating.
Benchmark alignment and active share
Equity portfolios must be run against free-float indices. While we understand why SEBI may look to full market cap for the purpose of defining the size of a stock, we believe it is important to either change this definition to free float OR indicate that there is sufficient flexibility in managing portfolios to close any gap between the two definitions.
Moving the stock market cap classification to “full market cap” instead of the commonly used “free float market cap”, will result in changing the market cap classification of several stocks, like PSUs as well as stocks with low free float, this may require higher levels of realignment in existing fund portfolios. Since the current set of benchmarks are on a free float market cap basis, this will also result in funds carrying higher active share and result in higher deviation from benchmarks in performance.
For instance, as per current market cap numbers, 15 stocks from the BSE 100 will be classified as mid cap stocks as per this definition. Many of these stocks are held by managers in their large-cap funds. While they still have the 20% non-large cap exposure option, it does limit them in taking additional non-large cap exposure. Similarly, fixed income funds may need customized indices being launched as the current set of commonly used fixed income indices will not match the mandates of many of the categories.
Tax impact
If the mandate of an existing fund undergoes a change or the mandate of the merged fund is dramatically different from what suits the investment profile of the existing investors, they may be forced to exit the fund. This may bring about inadvertent tax implications, especially in the case of fixed income funds where the holding period criteria for long-term capital gains is 36 months.
Clarifications required
SEBI will need to tweak the definitions of a few categories or clarify certain aspects. For instance, in fixed income categories they have clearly spelt out the required credit profile for “corporate bond funds” and “credit risk funds”. But in the case of “duration funds”, the circular is silent on what type of credits these can funds invest into. With no defined credit profile, there is a possibility that different credit profile funds could exist within the same category.
In the case of duration funds, the scheme characteristic requires the Macaulay Duration for the portfolio to be within a certain band, but the scheme descriptions only talk about buying securities within the defined “duration band”. If the latter is true, managers would be limited to buying securities only within the defined band. A restrictive move since a source of alpha has been deploying strategies to benefit from mispricing or expected movements in different points of the yield curve, while keeping the overall portfolio duration within the required band.
We are of the opinion that the condition as defined on a portfolio level should suffice.
We do expect a fair bit of interaction between the industry participants and the regulator to iron out most of these issues. The result will be a streamlined and clear product mix, which investors can look at, compare with greater ease due to the uniformity, and make subsequent informed decisions.
