Regulation 3.0—Indian Mutual Funds
The Securities and Exchange Board of India’s (Sebi) circular on mutual fund schemes’ categorization and rationalization was released on 6 October 2017. The eight-page circular (you can read it here) comes at the end of many years of regulatory nudges. What is the problem that Sebi is attempting to solve? Four problems. One, in the absence of definitions from Sebi on what is a large-, mid- and small-cap category, there has been confusion about what an investor is really buying. A large-cap fund could, therefore, have stocks that would be counted as mid-cap if a different definition was used for shortlisting a large-cap stock. Not just investors, but third-party analysts too found the lack of an industry standard difficult to deal with.
Sebi has now laid down the rules of what these three categories are. A large-cap fund can buy stocks of firms that sit in the bucket containing the top 100 stocks by market cap. A mid-cap fund can buy stocks from the bucket that has firms that fall between the 101st and 250th by market cap. A small-cap fund can buy stocks in firms that have a market cap from the 251st company onwards. The job of reconciling and putting out a list of these stocks twice a year has been given to the industry association, Association of Mutual Funds in India (Amfi). This was a long overdue basic hygiene step that will allow analysts and advisers to put out research and advice that does not have to worry about what definition to use. If we are in a market that rests on disclosure, then it is the job of regulators to make disclosures meaningful. This is a step in the right direction to bring an industry standard in the Rs20 trillion mutual fund industry.
Two, over the years, clutter has built up in the mutual fund industry with too many similar schemes even within a fund house. Historical reasons such as harvesting the 6% new fund offer charge that was allowed till 2006, had encouraged fund houses to launch similar schemes to harvest the charge. Merger of fund houses caused fund houses to have several similar schemes. Smart compliance officers also managed to get schemes past Sebi that essentially were no different from existing schemes. Sebi is now defining the market better. It has put out five broad mutual fund groups: equity, debt, hybrid, solution-oriented and others. Each group will have categories of schemes with asset allocation definitions. Each mutual fund will be allowed one scheme in each category. If a fund house has more than one scheme in a given category, it will have to merge it with the other scheme or shut it down. As an investor, when you now look for a large-cap fund, you will see just one large-cap scheme from each fund house rather than four or five schemes in that category that some fund houses had. It makes comparison, choice and decision-making easier for investors, analysts and advisers.
Three, balanced funds were unbalanced with some fund houses stuffing theirs with far too much equity. When investors would compare returns across the balanced fund category, the funds with equity higher than 70% would look much better than true-to-label balanced funds. Sebi had stopped giving approval to new balanced fund schemes that did not stick to the 50:50 allocation in the recent past, while allowing older fund houses to run existing (un)balanced funds. Sebi has now split this category into three. Conservative hybrid funds, known today as monthly income plans (MIPs), will have equity up to 25% and the rest debt. Best for retired people seeking a monthly income, the name of the fund now does not mislead investors into thinking that the monthly income is assured. A balanced hybrid fund will have an equity allocation of 40-60%. An aggressive hybrid fund (note that the name ‘balanced’ gets dropped here) can have an equity allocation of 65-80%.
Four, scheme names were misleading. For example, the MIP, which gave the impression of giving a guaranteed return, will now be called a conservative hybrid fund. The credit opportunities fund will now be called credit risk fund. The category was launched by fund houses to offer corporate bonds with less than triple A rating—higher risk bonds in the bag meant possibility of higher returns. For investors who can take the risk of lower-grade paper, this is a great category, but the name seemed to indicate only the upside and not the risk. Debt as an asset class is just beginning to be understood by retail investors. It is the duty of the regulator to ensure that investors do not misunderstand the product and take on higher risk than they should because of smart nomenclature.
There will now be 36 categories of mutual fund schemes and as my colleague Kayezad E. Adajania pointed out in this piece, there are too many debt fund categories. But it is good that Sebi has taken the next step to streamline the Indian mutual fund industry further. Ten years of heightened regulatory action is resulting in equity flows coming into the industry in an orderly and stable manner. This next piece of reform should get the industry ready for future growth as investors get a better handle on what they are buying.
Disclosure: the author serves on Sebi’s Mutual Fund Advisory Committee and was a member of the sub-committee formed to construct the contours of the rationalisation of schemes.
Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint and on the board of FPSB India. She ca