Sebi’s effort to streamline mutual fund schemes is long overdue

There cannot be any argument against the fact that regulations, which govern classification of mutual fund schemes, were long overdue for an overhaul. There are many instances where mutual fund houses came out with a new scheme which were of similar nature to an existing scheme, but just to increase their assets under management, mutual fund houses were repackaging them into a new scheme, leading to cannabalising and erosion in NAVs.

Also, changing the objective of mutual fund scheme and taking investor for ride has been a very common thing. Just to give a most glaring example of how asset management companies had been misselling —  between  2009 and  2012 many sectoral funds, which had raised money between 2006 and 2008 to invest in infrastructure companies, suddenly shifted their investment to banking sector which they were not supposed to do as per their offer document. The excuse given by them, banks provide finance to infrastructure companies so they could also be also classified as infra-plays. While the reality was that all asset management companies (AMC) had raised money in these sectoral schemes to execute the desire of investors to invest in what was perceived to be a burgeoning infrastructure sector. When they did not find the necessary opportunity in the infrastructure sector, rather than closing the schemes they invested in the flavour of the season, which was banking at that time.

So, when the market regulator, Securities and Exchange Board of India (Sebi) came out with a circular regarding categorisation of all mutual fund schemes across five categories — equity schemes, debt schemes, hybrid schemes, solution oriented schemes and other schemes, it appeared fine. However, there is one crucial aspect which the market regulator seems to have missed completely in this exercise.

As per the Sebi circular, a large cap fund would have minimum  investment in equity and equity related instruments of large cap companies to the extent of 80 per cent of total assets being managed in that scheme. Also as per Sebi circular, universe of large cap stocks would only consist of top 100 companies according to market capitalisation.

If a company which by market capitalisation criteria had a rank of 101, logically it would not find a place in the large cap fund. Which essentially means that a particular stock could only be bought into a scheme described as “large and mid-cap fund” in which, as per Sebi circular, minimum investment in equity and equity related instruments of large cap companies constituted 35 per cent of total assets. Also, minimum investment in equity and equity related instruments of mid cap stocks constituted 35 per cent of total assets.

Why should a unit holder of a large cap fund be debarred from the benefit of investing in a 101 ranked company as compared to a stock which is ranked 90 on a particular day, but has lower future potential of performance?

As per the Sebi circular, list of stocks falling in different categories — large cap, midcap and small cap will now be uploaded on the website of AMFI twice in a year. The fund manager will have to see whether their schemes are following  the criteria of market capitalisation investment and then make necessary changes within one month of the updating the list by AMFI.

Let’s examine a scenario which in all probability will soon be faced by a large number of fund mangers. If a stock which was not classified as large cap category in June review of AMFI has entered the category at the time of review in December? Should the fund manager who is managing a large and midcap fund sell that stock which has entered the large cap category?  Because if he does not, then he runs the risk of exceeding the market capitalisation limit which he is allowed for large cap stocks in a “large and a midcap scheme.”

Making a fund manager buy or sell the stock to readjust weightage of his scheme to market capitalisation is as good as forcing a fund manager to go against the basic principle of investing which is that stocks are bought and sold depending on fundamental changes either in a sector or the company and not because market cap has dropped below certain relative value to other stocks.

While the churn in the ranks of top 20 companies by market capitalisation is not very high, at the lower end of the so called universe of large cap set of stocks which are companies ranked 80 to 100 by market capitalisation do witness a constant churn as they keep moving in and out of top 100 companies. These changes would make the work of a fund manager much more difficult without adding value to the return which he generates for his unit holder. Many of these complexities will play out under the new regime, it remains to be seen how the regulator and AMFI react.