Has recategorization spread credit risk across debt categories?

By Morningstar Analysts |  11-06-19 | 

On October 6, 2017, SEBI’s Mutual Fund Advisory Committee (MFAC) announced the re-categorization and rationalization of mutual fund schemes.

An audacious move with the objective of benefitting the investor, the intent was to pull out duplicate funds of AMCs within a category.

The aim of recategorization was to bring about uniformity by clubbing funds with similar characteristics into one category. This would ensure that an investor can appropriately evaluate the options before deciding where to invest. Prior to this, standard definitions of mutual fund categories were missing, giving fund houses a free hand when it came to determine a scheme's characteristics and investment strategy, within a broad framework. (Morningstar as an independent research firm, has always followed standard category definitions by classifying funds as per their portfolio constituents.)

Further, fund companies had multiple schemes with similar strategies. Non-standard or ad-hoc category definitions, coupled with a large number of schemes, made it difficult for advisers and investors to meaningfully evaluate and compare options. This move was needed to eradicate confusion and simplify the process of fund selection.

DHAVAL KAPADIA, Director, Portfolio Specialist, and CHINTAN MEHTA, Senior Investment Analyst, of the Morningstar Investment Management (MIM) team, analyze the outcome of this move.

To an extent, the regulation has succeeded in its intent. Unfortunately, there has been an increase in the number of categories within equity and fixed income asset classes. In several instances, the category descriptions/characteristics aren’t clearly defined, providing ample flexibility to fund companies.

The result is that most funds have been re-categorized with just a change of name; and the fund managers continue to manage them in a similar fashion. This is further substantiated by the fact that the total number of funds merged/closed from the open-ended funds universe of approximately 860 funds is around 40 funds (less than the total number of fund houses in the country) with an average fund size of Rs 3,000 crore.

Equity funds

The category-wise descriptions, drafted by the committee, point out incidental room provided to the asset managers to fit their funds across categories. A classic example on the equity side would be to analyze funds from the larger fund houses. Earlier, one could undoubtedly find multiple funds offered by a single AMC, particularly in the Large and Multi-cap categories. Each category would host about 3 to 5 funds with almost similar mandates or style of management. Post the diktat, they continue to be managed similarly with just a shift change in category and name of the fund, which on paper might look like a significant move.

This exercise has led to fund companies flocking schemes in categories which have relatively flexible mandates: Large and Mid-cap, Multi-cap, Dividend Yield, Value/Contra, and Focused.

Duration funds

The story is not different on the debt side where the total number of categories is 16 with five categories having maturities up to one year. In certain cases, there are only marginal differences between categories which may not merit their existence. For instance, look at the duration buckets of three categories; short duration (1 to 3 years), medium duration (3 to 4 years) and medium to long duration (4 to 7 years). The medium duration category can quite easily be combined with the other two categories as the interest rate risk differential would be minimal.

Credit funds

The regulation has been successful in defining categories by providing a range for Macaulay duration. However, it has fallen short of providing a clear definition of the credit profile or the credit exposure that funds can take for most of the duration categories, including all categories below 1-year duration and several above 1-year duration.

Re-categorization has further provided flexibility to fund companies for classifying their credit risk heavy funds in different duration categories. The regulation could’ve clearly defined credit exposure that duration categories can take, which is all the more relevant in a bleak credit environment of defaults and downgrades, where duration funds are not only exposed to interest rate risk but also credit risk. There are funds across most of the fixed income categories (including those within less than 1-year duration) which carry substantial exposure to sub-AAA rated corporate bond segment. For instance, several funds in the short-duration category have more than 50% exposure to sub-AAA segment, including exposure to single A rated instruments ranging from 5% to 50%. Of which, few funds have more than 65% exposure to sub-AAA segment and these are not classified as credit risk funds!!

One would believe that the intent of creating a credit risk category was to segregate funds taking higher credit risk vis-à-vis other debt funds, thereby allowing investors and advisers to identify such funds in a concise and simple way. Clearly, this purpose has been defeated. Even banking & PSU and corporate bond fund categories have the flexibility of going up to 20% in sub-AAA segment (including AA, A and below rated papers). An investor would, therefore, have no option to select an only AAA rated corporate bond portfolio.

Hybrid category

There are six sub-categories here, some of them with only marginal differences. At first glance, there seems to be a distinction between the Aggressive Hybrid and Equity Savings categories. On further analysis, one can see that Aggressive Hybrid funds can invest up to 80% in equity whereas for Equity Savings it is 90%, a marginal difference. Further, the uniform scheme description states that Equity Savings funds could invest in equity, arbitrage and debt. The Balanced Hybrid category definition clearly states that ‘no arbitrage would be permitted in this scheme/category’ which isn’t mentioned in the definition for Aggressive Hybrid funds. Does that mean Aggressive Hybrid funds can invest in arbitrage? And how is it different from the Equity Savings category? This leaves room for fund companies to employ their own interpretation.

So what do we conclude?

The regulator has taken a step in the right direction as far as standard category definitions go. Although, it would have helped if it had drafted a limited number of categories and meticulously stated characteristics/description.

At the current juncture, this provides an opportunity for the mid and small-sized fund companies to launch funds within new categories and offer investors more options provided they are not duplicating any of the existing funds. On the flip side, the almost identical number of funds along with additional categories, both on the equity and fixed income side, adds to the confusion.

One way to tackle this could be to combine additional categories while analyzing funds. For example, one can group categories such as Multi Cap, Large & Mid Cap, Value, Focused, Contra and Dividend Yield, given that their mandates/category definitions are quite flexible.

Similarly, on the debt side one can group Short and Medium Duration, Banking and PSU, Floater and Corporate Bond categories. Low Duration, Money Market, and Ultra-short Duration as one category since the resulting interest rate risk differentials are marginal. Doing this might help in effectively analyzing funds.

A stark positive of the categorization exercise is that fund companies are restricted to only one fund per category. Restricting the number of categories with clearly defined characteristics could've had a more significant impact and benefited investors immensely. The regulator can consider appointing an independent research firm to assist in reviewing the categories and identifying funds which are duplicates, if in the first place the intent was to discard them.

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