Should The Regulator Alter Its Mutual Fund Categorisation Norms?
Jan 25, 2019

Author: PersonalFN Content & Research Team

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On 22nd January 2019, The Hindu reported that the capital market regulator is likely to review the mutual fund categorisation norms.

Many of you might be probably wondering why the capital market regulator would consider reviewing guidelines just within 14 months of issuing them.

Has it found any merit in the arguments industry representatives have made?

Or have new rules generated some unintended results?

You can't rule out both these possibilities.

If you remember, the capital market regulator had released reclassification guidelines in October 2017. Subsequently, mutual fund houses had churned their portfolio substantially to adhere to the new rules.

Before categorisation norms were implemented, the equity-oriented mutual funds were defining large caps, mid-caps, and small caps at their discretion, for the purpose of portfolio construction. As a result, comparing returns generated by two mutual fund schemes belonging to the same category was difficult since their underlying portfolios were drastically different.

To overcome this problem and help investors make better choices, the regulator decided to define market caps and directed mutual funds to maintain a minimum allocation in a specific market capitalisation basket to qualify their offerings in a particular product category.

For example, a mid-cap fund has a universe of just 150 stocks to select from to invest 65% of its assets. Moreover, it’s mandatory for a large-cap fund to invest at least 80% of its assets in large-cap stocks.

And as per SEBI’s current definition, top 100 stocks are large-cap stocks based on their 6 month average of total market capitalisation. Next, 150 stocks are mid-cap stocks and rest all are small-cap stocks.

In other words, there are 100 large caps, 150 mid caps, and 4,645 small caps. As a result, the universe of stocks available for large-cap funds is too small and that for small-cap funds is too loose.

[Read: Should You Invest In Small-Cap Funds In 2019?]

So, what are the possible unintended effects of this?

It’s become a challenge for fund managers of large cap schemes to generate market-beating returns. They might also find it difficult to compete with index-based Exchange Traded Funds (ETFs)

The problem of those managing mid-cap schemes is slightly different. Given the constraints on eligible stocks, managing impact costs has become crucial for fund managers. Mid-cap schemes with large Assets Under Management (AUM) might face this issue more frequently.

The National Stock Exchange defines impact cost as, the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time.

If the universe of available stock expands, they might have more options which would help them curtail impact costs. Higher impact costs negatively affect the performance of a fund.

What’s the remedy?

One of the industry personnel familiar with this development voiced industry’s expectations in this regard while speaking to The Hindu.

The view is that it would be better if the SEBI comes with a dynamic band or lays down a range in terms of market capitalisation for identifying firms as large-cap, mid-cap, and small-cap. That would also take care of the impact of the market volatility on the valuation of the companies.”

Although an official announcement on this hasn’t been issued from the capital market regulator, there are likely chances that SEBI might consider the matter if it sees any merit in industry representations.

In our view, the regulator has done its best to make sure that fund managers follow standard guidelines while creating a portfolio. Today, the new names announced by mutual fund houses, clearly differentiate each fund in terms of asset allocation and fund's investment strategy. So, the age-old practice of using fancy names for mutual funds has ended.

Do you need to take any action?

At present, the capital market regulator hasn’t taken any decision in this regard; thus you don’t need to reshuffle your portfolio or take any further action.

However, if the regulator allows certain changes that alter the investment mandate, the impact of it on the underlying portfolio has to be evaluated.

Currently, if you are investing in mutual funds in a less sophisticated manner—by not following your personalised asset allocation, it’s time to correct your mistake.

Please remember this before you invest in mutual funds…

  • Clearly identify your financial goals.

  • Assess your risk appetite. Only if you have a high-risk appetite and longer time horizon (at least 3-5 years) for the fulfilment of goals, invest more in equity-oriented mutual funds; otherwise, stick to debt mutual funds and other fixed-income investments.

  • Recognise the financial goals you wish to accomplish and align your mutual fund investments accordingly while you endeavour to compound wealth.

  • Gauge the time horizon before the financial goals befall.

  • Based on your risk appetite, draw up your personalised asset allocation and follow it diligently.

When investing in mutual funds, invest through Systematic Investment Plans (SIPs) and prefer direct plans.

[Read:Best SIPs To Invest in 2019]

PS: If you wish to take a calculated risk and invest in equity funds, PersonalFN can help you pick hidden gems or lesser-known funds that are capable of generating big gains for you.

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