The setting up of, Unit Trust of India (UTI) in 1963 marked the arrival of mutual funds in India. UTI was set up ‘with a view to encouraging saving and investment and participation in the income, profits and gains accruing to the Corporation from the acquisition, holding, management and disposal of securities’.

In 1993, the first set of SEBI Mutual Fund Regulations came into force for all mutual funds, except UTI. The entry of private sector funds in 1993 was the beginning of a new era in the Indian MF industry. The SEBI regulations were revised in 1996 comprehensively and in came SEBI (Mutual Fund) Regulations, 1996 that are in force. From the days of UTI, the mutual fund industry has come a long way.

Since 2014, the industry has seen steady inflows, surge in the AUM and wider choices of mutual fund products. The growth on various parameters in the industry coincided with a series of regulatory initiatives.

MF industry’s evolution

The industry has offered “products for all reasons and seasons” providing mutual fund schemes that suit the return-risk-liquidity requirements of the heterogeneous group of investors investing across different time frames.

As on March 31, 2022 there were 1,495 schemes offered by over 40 asset management companies and with over 14,480 scheme codes.

(A mutual fund scheme offers options like growth, dividend, income distribution-cum-capital withdrawal. Also, SEBI has mandated mutual funds to compulsorily launch from January 1, 2013, a direct investment plans, that is, investments not routed through a distributor. Hence, each scheme will have a direct and a regular plan. Each option and plan gets a specific code.)

Though people like having choices, too many choices increase the cognitive load on the human mind, more so when it comes to investing which is anyway taxing for many investors. The standard economic theories, assume investors to be making rational choices for themselves after evaluating all the available information.

In the securities market context, the standard finance assumptions are that investors capable of evaluating the risk-return attributes of various investment opportunities after taking into consideration all available information and make rational choices for themselves.

Research in human behaviour, on the other hand, has found that the assumption of rationality is misplaced. Investors are found to be not capable of acting rationally all the time. Also, many of them do not have the technical know-how of processing the information relevant for investment decisions. Human beings display bounded rationality.

Bounded rationality, an idea first introduced by Herbert Simon, refers to the fact that human beings do not have infinite cognitive abilities. Humans have limited computational skills. They also have flawed memories. Hence, the investment decision making process is not rational for many investors as there are limits on time, abilities and attention. When they are presented with too many complex information and details, the overload of information burdens the investors and derails them from informed decision making.

The best the investors can do is to recognise their limitations and be aware of their biases and cognitive errors, and work towards minimising the error cost.

Just the way to deal with limited memories, people make lists, they note down things as reminders, to deal with limited mental capacity people use short cuts and thumb rules.

Two initiatives

In mutual funds, regulators have prescribed these short-cuts to save the investors from excessive cognitive burden. Two regulatory initiatives are worth noting in this regard.

The first one is Categorization and Rationalization of Mutual Fund Schemes.

The idea behind SEBI’s circular issued is to ensure that an investor of mutual funds is able to evaluate the different investment opportunities, without getting lost in the plethora of funds available, before taking an informed decision to invest in a scheme. For example, equity schemes are sub-classified as Large cap, mid cap, small cap schemes etc., The regulator has also defined the large cap, mid cap and small cap stocks.

The regulator has also prescribed the naming convention of the schemes. Words that emphasise only the return aspect of the scheme are not allowed to be used in the name of the scheme. For example, scheme can no longer be named as ‘Credit Opportunity Funds’.

They are to be called “Credit Risk Fund”. The regulator has also ensured that schemes stay true to their names. When the regulator noticed that many multi-cap funds were having huge exposure only to large cap stocks, it ensured that a minimum 25 per cent exposure needs to be given to each capitalisation range i.e. large cap, mid and small cap stock to retain the tag of multi-cap scheme.

This standardisation across the product choices and clear depiction of schemes have significantly reduced the burden of fund selection at the broad level.

Product labelling through ‘Risk-o-Meter’ is another regulatory initiative which reduces the cognitive load on the investors. For labelling the various mutual fund products, the risk weight is calculated by taking into consideration the riskiness of each and every constituent of the scheme. For example, in case of investment in fixed income based funds credit risk, interest rate risk, liquidity risk is required to be understood.

For equity based funds market capitalisation of stocks, their impact cost and volatility contribute to the risk of the funds. Risk-o-Meter captures these aspects and displays the risk of the scheme in a simple manner.

Mutual fund schemes are risk labelled: (i) Low Risk; (ii) Low to Moderate Risk; (iii) Moderate Risk; (iv) Moderately High Risk; (v) High Risk; and (vi) Very High Risk. This saves investors of the challenge of going through complex computations.

The writer is Professor and HOD, School of Securities Education, National Institute of Securities Markets (an education initiative of SEBI)

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