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Business News/ Money / Personal Finance/  How the two-tier benchmark rule helps investors
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How the two-tier benchmark rule helps investors

Tier-1 benchmark shows the risk matrix and  tier-2 the investment style

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The two-tier benchmarking structure mandated for mutual funds by the Securities and Exchange Board of India (Sebi) last October, will lend force to the potential risk class (PRC) matrix introduced in December. This will help investors compare funds better before investing. 

While the new benchmarking guidelines are applicable to all mutual fund categories, recent changes would be particularly useful in capturing the granular risk elements of debt mutual funds.

To understand the changes, let us start with a brief look at the PRC matrix.

Matrix decoded

The PRC is a 3x3 matrix that showcases the maximum risk a debt mutual fund will take in terms of credit and interest rates. The credit risk is classified into three buckets —class A, B and C—basis the weighted risk value of each instrument accorded by the regulator. 

The interest rate risk, on the other hand, is measured in three blocks—class I, II and III—using the Macaulay duration. 

Asset management companies are required to place their schemes in the PRC grid for investors to understand the maximum risk associated with these. 

If a scheme takes a higher risk than that signified by the PRC bucket it is placed into, it implies a change in its fundamental attribute, thereby allowing investors to exit the scheme without incurring an exit load.

Following those guidelines, mutual funds started including a risk-o-meter to showcase the risk associated with the scheme and the PRC to showcase the maximum risk. 

However, mutual funds also continued to benchmark their schemes to indices representing the category of that scheme. For example, a short-duration fund was benchmarked against the CRISIL Short Term Bond Fund Index, which may not have a credit allocation similar to the scheme or to the PRC of the scheme.

Benefit of benchmarking 

The new two-tier benchmarking rules help address this. The tier-1 benchmarking index tells the investor which risk matrix is being followed by the debt fund, while the tier-2 index reveals the strategy adopted by it vis-à-vis the category definition, thereby highlighting any style deviation. 

Further, the comparison with tier-1 benchmark can help investors gauge the effectiveness of the strategy adopted by the fund manager within the category and the PRC bucket. 

Tier-2 benchmark that is expected to have the strategy of the fund more closely represented can help investors gauge alpha vis-a-vis the focused strategy adopted by the fund. 

So far, only a small number of schemes in the domestic mutual fund industry have declared their tier-2 benchmarks as these are not mandatory.

However, the benefits are there for all to see. For instance, a fund in the ultra-short-term fund category that is following a more liquid portfolio strategy aligned with liquid funds and has identified the liquid fund benchmark as its tier-2 benchmark. 

Similarly, some funds in the corporate bond fund category have identified AAA short duration bond index as their tier-2 index in line with their investment strategy to invest in top-rated short-term papers. Another fund in the banking and PSU fund category has selected the roll-down strategy benchmark index in line with its strategy.

To reiterate, therefore, the two-tier benchmarking index structure is expected to further enhance disclosures in the mutual fund industry. 

Mapping of the risk of debt funds with the PRC will also enable better comparison of the funds within the same category, instead of comparing all funds in the peer set on the same parameter – grouping can now be done basis tier-1 and tier-2 benchmarks. 

That said, individual spadework remains critical as ever for investors.  For instance, while the PRC matrix will showcase the maximum risk a scheme could take, the fund manager may choose not to invest till the thresholds. 

Thus, the matrix-based classification serves only as guidance. It is important that investors look at these parameters in conjunction with their own due diligence on the scheme’s portfolio.

Piyush Gupta, director, Funds Research, CRISIL.

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Published: 08 May 2022, 09:59 PM IST
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