Will Reviewing Curbs on Mutual Fund’s Equity Investment Benefit Investors?
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In early 2018, market regulator SEBI had introduced categorisation and rationalisation norms for mutual funds. The aim was to bring uniformity in the characteristics of similar type of schemes different mutual fund houses launched. The move was primarily to enable investors to make an informed decision before investing in a scheme. SEBI may now review the existing investment classification norms for mutual funds based on inputs from the mutual fund industry.
These norms clearly defined classification for large, mid, and small cap funds and did not exist earlier. In the past, due to the absence of any clear definition, fund managers had the leeway to classify funds based on their own parameters. This made it difficult for investors to compare schemes of different fund houses within a particular category.
To resolve this, mutual funds were classified as follows:
Large cap fund - A fund investing minimum 80% of its assets in large cap stocks (top 100 companies in terms of full market capitalisation)
Mid cap fund - A fund investing minimum 65% of its assets in mid cap stocks (companies ranking 101st to 250th in terms of full market capitalisation)
Small cap fund - A fund investing minimum 65% of its assets in small cap stocks (companies 251st onwards in terms of full market capitalisation)
The fund managers, however, found the new rules to be restrictive and determined the norms were responsible for the underperformance of equity funds. Mutual fund across categories had to undertake large scale reshuffling of the portfolio to align with the new norms, which resulted in a decline in share value. Large cap funds in particular found it extremely difficult to generate alpha due to the narrow universe of stocks.
[Read: Do You Own Equity Mutual Funds That Have Underperformed Their Benchmark? Read This!]
Hence, many fund houses have asked SEBI to reconsider the curbs that could widen the scope of investment and improve their ability to outperform. SEBI is reportedly in the process of reviewing the curbs and may soon come out with notification.
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The new norms are expected to provide fund managers more flexibility to manage large and mid cap investments. For example, large cap funds may be redefined to include top 125-150 stocks. Mid cap funds could include the next 200 stocks, while the rest could be included in small cap funds.
Widening the large cap and mid cap list would provide fund managers more options in portfolio construction and increase liquidity into the mid cap space. This could help in reducing the polarization we currently see in the equity markets. It is expected to improve liquidity for smaller stocks.
However, one potential risk is that small cap funds will have to choose stocks from an even lower market cap. If growth opportunities are not available in smaller caps, it could make these funds even riskier. This could curb inflows into the category.
Besides, any major change in categorisation would mean that fund managers, who have only just started getting used to the new norms, will have to reshuffle their portfolios again. This is likely to hit the NAV of the schemes and impact the returns.
Moreover, given that the many stocks are already battered to the pandemic impact, a rejig in mutual fund classification at this stage could add to the investors' pain.
[Read: Should You Stop Investing in Equity Mutual Funds Generating Returns Lower Than a Bank FD?]
If the regulator does reclassify the stock universe for mutual funds, you need to evaluate if this leads to changes in the fundamental attributes of schemes you have invested in. The new fundamental attributes may or may not align with your risk profile and investment objective.
If you wish to invest in a diversified portfolio of equity funds that can not only outperform during the market recovery, but also contain the downside if the volatility persists, opt for the 'Core &Satellite' approach to investing.
The 'Core' part consists of the more stable, long-term holdings of the portfolio consisting of large-cap fund, multi-cap fund, and value style fund. Whereas, the 'Satellite' part consisting of mid-cap fund, large & mid-cap fund, and an aggressive hybrid fund can help push up the overall returns of the portfolio.
Weights to each of these categories should be assigned after careful evaluation of your risk profile and investment objective.
If you wish to invest in a readymade portfolio of top recommended equity mutual funds based on the 'Core & Satellite' approach to investing, I recommend that you subscribe to PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025 (2020 Edition)". This premium report will help you build your optimum mutual funds portfolio for 2025 without any effort on your part. If you haven't subscribed yet, do it now!
Warm Regards,
Divya Grover
Research Analyst
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