Why SEBI’s Guidelines on Mutual Funds’ Categorization and Rationalization are Flawed

Market regulator SEBI has issued a circular defining categories for mutual fund schemes, and the number of funds permitted under each category. Consequently, fund companies will be forced to either merge or liquidate all additional schemes.

For some time now, there have been rumours that SEBI has been nudging fund companies to reduce the number of schemes on offer. By issuing a circular, SEBI has forced fund companies to act.

I have no hesitation in saying that several Indian fund companies have been poor stewards of investors’ monies. They have been guilty of recklessly launching funds (often with poor investment rationale) with the sole intent of shoring up assets.

Furthermore, I believe that SEBI acted with the best of intentions, to aid investors make informed decisions by easing the selection process.

That said, I’m afraid that SEBI’s solution is flawed because it lacks nuance, and is unlikely to result in an improved investment experience for investors.

Is fewer options necessarily better?

Clearly, the guidelines are aimed at (a) reducing number of funds and, (b) bringing uniformity among funds in each category.

So, if the new fund offer (NFO) launch spree resulted in too many funds (read choices) for investors. SEBI's solution is on the other end of the spectrum—extinguish a number of funds, thereby sharply reducing choices available to investors. I'm not convinced that the latter is necessarily in investors' best interests.

Let's take an example to better understand why limiting choices need not be a good idea.

With the exception of three categories, the guidelines state that one fund is permitted per category. Hence each fund company can have say, one Large Cap fund.

Even a cursory glance at the present large cap funds reveals that there exist funds of different hues and colours.

There are funds that take cash calls, and others which are fully invested at all times; some which adopt a buy-and-hold stance and others that churn the portfolio rapidly; funds with benchmark-agnostic and benchmark-aligned portfolios.

Many of these contrasting investment styles can be found in the same fund company. Each investment style is apt for an investor with a distinct risk profile.

However, SEBI's guidelines could result in investors not having access to funds that are apt for them.

In a move that is seemingly at odds with what the guidelines aim to achieve, categories such as Dividend Yield Fund and Value/Contra Fund have been permitted. But how does one define what constitutes a dividend yielding stock, or a value/contra pick for that matter? One can’t since, there is no universal definition.

In effect, fund companies have been handed a loophole that they can freely exploit. Such a scenario can negate SEBI’s intent to ‘standardize characteristics of each category’.

Status quo for close-ended funds

In a major gaffe, the guidelines are applicable only to open-ended funds. The close-ended funds segment, which is a hotbed of questionable funds with little differentiation, and rampant mis-selling will continue to thrive.

I won’t be surprised if we see a large number of close-ended NFOs being launched in the days to come.

Bloated asset sizes of merged funds

To my mind, not many funds will be liquidated in light of the ‘one fund per category’ rule. Liquidating funds means loss of assets, and in turn, loss of revenue for the fund company.

Instead, we will see a record number of mergers. In several cases, the merged fund will have a bloated asset size making it unwieldy. Liquidity management issues could crop up, adversely affecting the performance. 

All in all, the guidelines may have been well-intentioned, but I fear this will end up as a case of throwing out the baby with the bathwater.