How mutual fund classification will impact your portfolio

By Renu Yadav  
Tuesday, October 24, 2017

At the time when equity mutual funds are receiving massive monthly inflows in equity and balanced mutual funds, going up to around  Rs 25,000 crore, the capital markets regulator Securities and Exchange Board of India (SEBI) has come out with new classification of mutual funds. It's intended to make the mutual fund selection process easier for investors.

According to the new classification, the mutual funds schemes will be classified into five broad categories-- equity schemes, debt schemes, hybrid schemes, solution oriented schemes and other schemes. Solution-oriented schemes will be retirement or children funds.

Equity schemes can be further classified into 10 sub-categories such as large, mid, multicap, small cap et. Debt schemes can be classified into 16 sub-categories while hybrid funds can be further classified into six sub-categories. Only one scheme per category will be permitted. Sector or thematic funds, closed-end funds, fund of funds are kept out of the purview of this classification.

Fund houses have been given two months time from the date of the circular to review their classification and submit the proposal with SEBI. And after SEBI clears their proposal they will have to carry out the necessary changes within three months time. Schemes will be comparable: The biggest advantage of this classification is that it will make mutual fund schemes comparable. Right now it's a bit difficult as each fund has its own definition of large-cap, mid and small cap stocks. Therefore, even in a large-cap category the weighted average market capitalisation of mutual funds range between 29,000 crore to 1,90,000 crore. In order to bring in uniformity among fund classification, SEBI has also given the definition of large, mid and small cap stocks.

Large cap will be defined as 1st to 100th companies in terms of full market capitalization. 101st to 250th company as per full market capitalization will be termed as mid caps and from  251st company onwards will be classified as small cap.  

"This new classification will ensure that for example if an investor has invested in a large-cap fund, it will remain a large cap fund throughout," says Manoj Nagpal, CEO, Outlook Asia Capital.

There won't be duplication of schemes as it is happening right now where a fund house has two or more schemes in a category with similar strategy.

Also, among debt funds the classification has been made much more clearer as per the weighted average maturity of the portfolio. New categories has been introduced by SEBI such as overnight funds which will invest in securities with duration of just one day.   

However, Vidya Bala, Head of Mutual Fund Research at  FundsIndia believes that SEBI has not addressed the credit risk in the new classification of debt funds as it is currently based on only average maturity which may not be very helpful for the retail investor. "There are broadly eight categories of debt funds right now while as per new classification it will go up to 16. SEBI could have retained the existing classification and defined them more clearly in terms of average maturity and credit risk," says Bala.  

Performance may be impacted: There are three reasons why the scheme's performance will be impacted with the new classification.

a. Right now funds, even a large cap fund, has the liberty to invest a portion of their portfolio in mid and small cap stocks, which helps them generate alpha. "This is called style drift and it may not be possible after the new classification is implemented. Therefore there may be lesser alpha generation compared to benchmark," says Manoj Nagpal of Outlook Asia Capital. "Right now the alpha generation is done through stock picking while going forward fund manager will be able generate alpha by being underweight or overweight on stocks as compared to benchmark or peer as the universe will be limited and same for all, " says Vidya. b) As per the new mandate, if a fund wants to be classified as a large-cap fund then it will have to invest in the stocks defined as large-cap by this regulation. Therefore, it will have to buy some stocks or may have to sell few which will have an impact cost in the short-term and will have to be borne by the investor.c)Finally, the fund will have to rebalance the portfolio as per the list of large, mid and small cap stocks published by AMFI on a six monthly basis.

So, if a stock has become large-cap as per the definition then a mid cap fund won't be able to hold it even if the fund manager sees potential in it. So, this will result in forced selling and may impact the performance of the fund.

However, the new classification is considered a step in the right direction as it will bring clarity, uniformity among mutual fund buts investors may see some impact on performance over short-term.

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