Come October, mutual funds will be celebrating the seventh anniversary of a regulation that vastly simplified life for investors, but complicated it for Asset Management Companies (AMCs).
This was Securities Exchange Board of India’s (SEBI) new regulation on scheme categorization. With the money managed by funds and the risk appetite of investors changing beyond recognition in since then, it is time SEBI revisited this regulation.
What they were
In October 2017, SEBI put out a landmark circular that aimed to simplify and standardise choices for investors and ensure truthful labelling by mutual funds.
The circular required AMCs to bucket all their current and future schemes into 36 defined categories. AMC could offer only 10 types (categories) of equity funds, 16 categories of debt funds and six varieties of hybrid funds, apart from a couple of solution-oriented funds.
The tougher stipulation though, was that every AMC could offer only one scheme per category. The exceptions were thematic and passive funds. This triggered a major overhaul for the industry which then merged, renamed and restructured over 800 open-ended schemes.
To ensure that AMCs didn’t try to fit square pegs into round holes, SEBI laid down portfolio boundaries for each category. So, a large-cap fund must invest 80 per cent in the top 100 stocks by market capitalisation. Mid-cap funds had to invest 65 per cent in the next 150 stocks by market cap, while small-cap funds had to have 65 per cent in the residual stocks. A short duration debt fund had to stick to a portfolio duration of 1 to 3 years, and so on.
What it achieved
These rules had the effect of greatly simplifying choices for investors. An investor buying a large-and-midcap equity fund, for instance, would know that it would park at least 35 per cent each in large-caps and mid-caps — this wasn’t the case before.
Comparing, ranking and benchmarking schemes also became easier. Funds could not prop up their performance by straying away from large-caps into small-caps or from AAA-rated bonds into BBB ones.
The transparency from all this, has no doubt contributed to the soaring popularity of mutual funds. Between 2017 and now, individual mutual fund assets have galloped from ₹10 lakh crore to ₹40 lakh crore. The monthly Systematic Investment Plan book has shot up from ₹3,434 crore to ₹23,547 crore (Source: Franklin Templeton Mutual Fund Dashboard).
However, the manifold expansion in assets within the categorisation framework, has also given rise to serious challenges.
The size problem
One, popular schemes in the industry are now becoming too big to sustain their performance.
In the open-end structure, mutual funds that rack up a good show attract larger and larger flows. Seven years ago, leading large-cap and mid-cap funds managed ₹10,000 to ₹15,000 crore. The most popular small-cap funds had ₹4,000-5,000 crore. The leading flexicap fund managed ₹20,000 crore.
Today, after relentless inflows, top large-cap and flexi-cap funds manage ₹60,000-70,000 crore. Popular mid-cap funds have assets of ₹50,000 to ₹75,000 crore. Leading small-cap funds juggle ₹30,000 to ₹60,000 crore.
This manifold expansion in mutual fund assets hasn’t been matched by an expansion in cash market depth. To build a 5 per cent portfolio position, a ₹50,000 crore fund needs to invest ₹2,500 crore in a single stock. But today, top traded stocks on the NSE see daily cash volumes of ₹1,000 crore to ₹3,000 crore. Volumes drop off a cliff when you go beyond the top 100.
Therefore, a fund looking to build a ₹2,500 crore position has to phase out its buying over many sessions. Even then, it can suffer from high impact cost, which jacks up the price of the stock. Some funds get around this by settling for 2 or 3 per cent positions in their top names. This leads to unwieldy 70- or 100-stock portfolios. These issues over time dilute fund returns, saddling successful funds with a winner’s curse.
It would be a real pity if the size problem forces Indian investors to turn away from seasoned funds which have survived market cycles, to untested newbies. Therefore SEBI must look to relax its one-scheme-per-category rule.
AMCs must be allowed to launch a second or third scheme in a category where they have a track record. To ensure that they don’t clone without good reason, Total Expense Ratio (TER) limits can be pegged to cumulative assets managed by an AMC in a category.
Prevents gating
The world over, when mutual funds feel that markets are over-heated or their funds have gotten too big to perform, they stop fresh inflows. Such gating doesn’t hurt their prospects because they can still launch new schemes with the same mandate.
But in India, AMCs seldom take the decision to completely gate flows, despite size problems. This is because the one-scheme-per-category rule restricts them from new launches which can keep their growth going. Therefore, fund managers air their frustration about expensive markets, but do little about it.
Thematic fund overload
In any commercial activity, if you shut the door to growth, businesses try to open new windows. With mutual funds, this has taken the form of thematic fund and passive fund launches.
As established AMCs have run out of quotas in mainstream categories, they have been garnering assets through new fund offers (NFOs) of thematic and passive products. These are the only two fund categories that are exempt from SEBI’s one-scheme-per-category rule.
In the last year, of the ₹3.07 lakh crore in net flows into equity funds, sectoral and thematic funds mopped up ₹1.22 lakh crore. Diversified categories such as large-cap funds and flexi-cap funds collected about ₹10,200 crore and ₹29,000 crore respectively (FT MF dashboard).
This is likely to lead to a sub-par investor experience in the long run. Sectoral funds are risky and require astute timing. Funds piggybacking on themes such as business cycles, defence or tourism tend to be loosely labelled or focussed on expensive market themes. Passive funds on factor indices such momentum, alpha, etc are complex and bet on investment styles that are hard for investors to decipher.
Reining in innovation
With categorisation rules pigeon-holing the kinds of schemes AMCs can offer, the industry has all but given up on innovation.
Today, new players entering the business are either staying with passive funds or launching me-too versions of the same old products.
Retail investors meanwhile crave more sophisticated and risky products and are migrating to high-ticket vehicles such as Portfolio Management Services (PMS) and Alternative Investment Funds to try out new strategies. Those without the money to spare are turning easy prey to unregulated entities offering “innovative” products.
To cater to these investors, SEBI has recently floated a consultation paper on a new asset class between mutual funds and PMS, where it has invited AMCs to offer new product ideas. Some of these ideas can fit well into the mutual fund structure itself, if SEBI is willing to relax the 36-category rule.