Spring cleaning mutual funds in the monsoon

This year the annual update of Mint50, the curated list of 50 investment-worthy mutual funds got a six-month delay. We usually release the list in January of the year with a list of funds that have moved out and those that have moved in. But this year was different because capital market regulator Securities and Exchange Board of India (Sebi) changed the rules of the game, making a big change in the industry. The changes needed to play out before we could do our research ahead of the new list. The new list is now out and our big change is that we have shrunk the 50 mutual fund list to 30.

What was this change and why is it important? Sebi did two things. One, it divided up the industry into 36 categories of funds, allowing every fund house to have one scheme in the category to reduce the clutter in the industry. Read this column where I had suggested that this is the way to go forward to bring order in the industry in 2015. It took two years for Sebi to finally push funds into doing this. Sebi has left the door open for new innovations that will get their own categories as markets mature further. Mutual fund companies were launching too many schemes that replicated the older schemes causing investor confusion. By defining categories and being very generous with the number of categories, Sebi has left plenty of elbow room for the fund houses to place their funds in a category they think the scheme serves.

Two, it defined the 36 categories fairly tightly so that interpretation was not left to the fund houses. This was needed because the rules of the game were old and needed a change. What worked for an industry size of ₹ 47,000 crore in 1993, was not going to work for a ₹ 23 trillion giant 25 years later. Sebi’s change makes the mutual funds more “true-to-label”. Before this regulatory change, fund houses were free to use their own definitions for different categories. For example, a large-cap fund could have a large exposure to mid-cap stocks, or a balanced fund could be 80% in equities. This made comparisons very difficult for investors and listings like Mint50. Take the case of a balanced fund—it was difficult to include a true balanced fund in our list of investment-worthy funds when another with 80% equity was showing far superior returns. But a risk averse investor, who wanted a balanced fund with half equity and half debt, would look at the word “balanced” and look at the superior returns and pick a scheme that was far riskier. Among other things, Sebi has now defined what stocks classify as “large cap”, “mid-cap” and so on. It has defined limits of what percent of stocks a balanced fund can hold. The definitions make the schemes in the category very similar and now true fund manager skill can be evaluated.

Also Read: Here’s how to pick a mutual fund from 14 new Sebi categories

Some of them went kicking and screaming, but now all mutual funds have gone through a process of renaming, redoing, merging or removing schemes to fit the Sebi definitions. Think of this as a big house clean where the clutter is removed and things are put into neatly labelled boxes. This rejig of the categories and definitions made it necessary for Mint50 to change as well. When we did the audit we realised several things. One, the large-cap category was now truly holding only large-cap stocks, or stocks that are in the top 100 by market cap bucket. We did not need to cater to different styles of fund management within the large-cap category, reducing the number of schemes needed in the category. We also realised that alpha is getting more difficult in the large-cap category and have put the category itself under watch for the future. Alpha, very simply, is the extra return the fund manager gives over the benchmark. If the Sensex returns 10%, and the fund gives 15%, then 5% is called the alpha.

Two, you don’t need to have schemes from all the 36 categories but need just a few. Most retail investors don’t need very complicated portfolios. It is only when the asset size becomes very large that the need for more diversification and more complicated strategies could arise. We, therefore, decided to not include all the 36 categories in the list. Within the chosen categories too, we reduced the number of funds. This shrinks the list of 50 schemes to 30. A tighter focus on quality funds sitting in well-defined categories will also make your job easier when you select the 5-8 schemes that are needed to build your portfolio.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation