Mutual funds have several categories. Among equity funds, based on market cap, you have large, mid- and small-cap funds.
The Securities and Exchange Board India (Sebi) is likely to usher another round of far-reaching reforms for the Rs 20 trillion mutual fund industry soon. Senior officials of the market regulator have given indications that the thrust of these will be on reducing the number of schemes available to investors in each category and introducing clearer definitions, so that investors find it easy to choose the right schemes for themselves.
More schemes may be merged: Currently, around 2,000 schemes are available to investors. Many fund houses have multiple schemes in the same category, not so different from one another. In recent years, Sebi has become tougher on new fund offers (NFOs), not allowing one unless the proposed scheme is different from a fund house's existing offerings. The regulations weren't always so strict, with the result that some fund houses have multiple schemes in the same category. “This creates a non-level playing field among fund houses,” says Nilesh Shah, managing director, Kotak Asset Management Company (AMC).
The market regulator is likely to stipulate that fund houses offer only a limited number of funds in each category. “When you have too many schemes, it confuses investors. This move towards simplification of choices will be a positive step,” says Shah.
Scheme mergers will also result in lower expense ratios of funds. “Sebi has a slab-based rule for charging expense ratio. A lower rate is charged in higher slabs. When two funds are merged, the assets under management of the new entity will be higher. So the average expense ratio will come down,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.
Fund categories to be clearly defined: Mutual funds
have several categories. Among equity funds, based on market cap, you have large, mid- and small-cap funds. “At present, each AMC follows its own definition of large-cap, mid-cap and small cap. The existing guidelines are very broad-based,” says Sunil Subramaniam, chief executive officer (CEO), Sundaram Asset Management.
This ambiguity has given rise to several anomalies. For instance, in the case of mid-cap funds, there is no uniform definition of a mid-cap stock that all must follow. In portfolio construction, there is no clear guideline on whether a fund must have a 60 per cent exposure to mid-cap stocks or an 80 per cent exposure to qualify as a mid-cap fund. “Offer documents of some funds have mid-cap stocks defined in a market cap range. Others, filed earlier, don't have such restrictions as it was not required then. Hence, they are free to invest in large-cap stocks in a mid-cap fund,” says Shah.
Within the balanced fund category, some were approved earlier when there were no restrictions on their asset allocation. So, they can allocate as much as 75-80 per cent in equities. The cap on equity allocation was gradually lowered and now stands at 50 per cent. So, you have a range of balanced funds with equity allocations varying from 50-90 per cent. This leads to a wide range of performance. Investors, who go primarily by past performance, put their money on the highest-performing funds within the category, not realising these might also carry higher risk.
Ambiguous categorisation also results in style drift. When markets
are rising, mid-caps typically tend to run up faster than large-caps. Many large-cap fund managers build high exposures to mid-cap stocks to shore up his returns. “Tighter definition of categories will prevent style drift and ensure fund managers remain true to their mandate,” says Dhawan.
According to experts, Sebi is likely to define fund categories clearly. All funds within a particular category will then have to invest in stocks belonging to a similar market cap range. “Such clarity on categorisation will make comparison between funds more relevant,” says Subramaniam. Fund houses might have to fit all their funds into one category or another, and close down or merge those that don't fit in.
Clarity on nomenclature: Today, many funds carry names that are difficult to correlate with their actual nature. Some balanced funds, for instance, are called ‘prudence’. Some funds have ‘growth’ in their names but are value funds. Beside making it difficult for investors to make the right choice, such naming enhances the scope for mis-selling.
Expense ratios may be slashed: At a recent event hosted by the Federation of Indian Chambers of Commerce and Industry, G Mahalingam, whole-time member at Sebi, said: “ Today, if you look at the total expense ratio of the mutual fund industry, it is far more than comfortable and favourable compared to many other jurisdictions. We should now examine, with volumes improving, if we can bring down the total expense ratio.” This has led to the expectation that Sebi might look to cut expense ratios. According to experts, one way is by changing the existing slab structure. Says Manoj Nagpal, CEO, Outlook Asia Capital: “If Sebi is keen to lower the expense ratio, it could rationalise the 30 basis points it allows fund houses to charge for enhancing penetration in B-15 (beyond 15 or smaller) towns or the 20 basis points they can charge in lieu of exit load.”
Investors need to be alert: After a fund merger, an investor could become too heavily exposed to a particular fund manager. The investor could also find himself in a scheme not among the better performers in its category. The very character of the fund could change. All these situations would require investors to exit their current fund. However, unlike in the past, fund mergers do not create a tax liability anymore. So, there is no need for investors to act in advance. Wait for the new guidelines to come in, understand these, and then act.