CIRCUIT BREAKER. Better ways to clean up mutual funds

Last week, after years of debate, the Securities and Exchange Board of India embarked on a Swachh Bharat-type mission to declutter the Indian mutual fund industry. Such spring-cleaning is sorely needed. The MF industry has seen its fair share of ‘consolidation’ in the last decade but this has made very little difference to the number of schemes on offer. The 45 Asset Management Companies (AMCs) today offer over 1900 schemes between them.

Vaguely defined investment mandates add to this befuddling cocktail of choices. It is quite usual in the Indian context for a ‘bluechip’ equity fund to park a third of its portfolio in mid-cap stocks and for a liquid fund to invest in barely liquid AA-rated bonds.

SEBI’s latest circular on categorisation and rationalisation of mutual fund schemes proposes three new rules. One, all AMCs are henceforth required to classify their open-end schemes into just five categories — equity, debt, hybrid, solution-oriented schemes and others (only index funds and fund-of-funds). Two, they should further classify their schemes into SEBI-approved types. It has provided a readymade list of 10 types of equity funds, 16 types of debt funds, 6 types of hybrid funds and 2 solution-based products. No AMC can run more than one scheme under each type. Three, to ensure truth in labelling, SEBI has asked all AMCs to ensure that their schemes stick to mandates defined by it. For instance, it defines a large-cap fund as one which invests a minimum 80 per cent in the top 100 stocks by market capitalisation. A focussed fund cannot own more than 30 stocks. A long duration fund needs to maintain a minimum portfolio duration of 7 years.

AMCs are expected to evaluate all their schemes under this new framework and get back to SEBI with concrete plans to merge, wind up or tweak the ones that don’t fit in. But elaborate as they are, these rules don’t completely solve the problem for fund investors. On some counts, they may also stifle innovation.

SEBI’s attempt to make schemes define their labels better and stick to them is certainly welcome. After all, when a retiree buys a large-cap fund, he’s hoping to own established firms with lower volatility in stock prices. If that fund drifts into mid-cap stocks, it is longer a good fit for his risk profile. Now, he can be fairly certain of what he’s buying and the scheme will not even have wriggle-room on what it treats as a large, mid or small-cap stock. In debt schemes, there is similar clarity on duration, allowing investors to match their own holding period with the funds’.

But then, the market cap tilt of an equity fund or the duration policy of a debt fund is just one aspect of the investment mandate that investors would be interested in. A liquid fund which sticks to the SEBI definition on 91-day maturity can still take outsized risks by owning A-rated corporate bonds. In an equity fund, it matters a great deal to the investor whether the scheme takes cash calls, and whether it owns a concentrated portfolio.

This is why, instead of spoonfeeding AMCs with rigid mandates, it may be better for SEBI to provide some indicative mandates and then allow AMCs to come up with new ones on their own. It can, however, insist on the mandates being precise and quantifiable. For instance, every equity scheme can be required to state upfront its market cap limits, cap on individual exposures, style of investing and cash-holding limits. Schemes which stray from their stated mandate must be flagged and penalised.

SEBI’s requirement that all AMCs have only one scheme of each ‘type’ is intended to simplify choices for investors and reduce duplication. There are instances in the industry of the same fund house offering two ELSS schemes, two balanced funds or multiple corporate bond funds. This doesn’t just confuse investors, it also creates tricky allocation issues. Which of the schemes with similar mandates should get the more experienced fund manager or the better stock picks? The new rules may force such schemes within an AMC to merge or wind up.

But then, given that each one of the 45 AMCs can still offer 34 different types of schemes, it is doubtful if the simplification objective will be met. Investors can still theoretically be bombarded with 450 different equity schemes, 720 debt schemes and 270 hybrid schemes, apart from an unlimited number of sector funds and ETFs. That close-end schemes have been kept entirely out of the purview of these regulations is another big constraint. With SEBI tightening the screws on open-end scheme launches in recent years, AMCs have been going the whole hog on close-ended schemes. At last count, the industry managed 1084 close-end schemes (as opposed to 829 open-end ones) which are unaffected by these regulations.

Finally, there’s the question of whether SEBI’s cookie-cutter approach to classifying funds will stifle innovation. In drawing up its list of approved fund types, the regulator has mainly gone by the schemes already offered by the leading Indian AMCs. Most Indian equity schemes already define themselves based on market cap buckets and debt funds swear by duration. But who is to say that this is the ideal categorisation for investors?

Many first-time investors in debt funds, for instance, would like to own a long-term fund that delivers regular income that is slightly higher than a bank FD. They couldn’t care less about the duration profile. First-time equity investors may prefer a multi-cap fund that protects downside risk by moving to cash. But there is no classification for such in-between products.

Seasoned MF investors may like to graduate to sophisticated global products that go beyond the current fund types. Absolute Return Funds, Target Date Funds or Socially Responsible Funds are yet to debut in India. Let’s not forget that, not long ago, even Equity Savings Funds, Credit Opportunities Funds and Focussed Equity Funds were alien concepts but have been ushered in by innovative AMCs.

Overall, SEBI should probably be more flexible about its idea of pigeonholing all MF schemes into pre-set categories. If a simple menu of offerings for first-timers is its goal, it must encourage all AMCs to offer at least one go-anywhere equity fund and one go-anywhere debt fund on their menu, without forcing the investor to make complicated choices on market cap, style, duration or credit. Let the seasoned investors be offered as many fund categories or types as they would like.

In fact, more than such rationalisation, it is thriving competition that AMCs in India need, to offer their investors a better deal. SEBI should make every effort to ensure that Indian investors have access to robust new categories of passive funds that give active fund managers a good run for their money.

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