SEBI's proposed mutual fund revamp tackles multiple problems but misses these outdated rules

Time of India

5 days ago

Seven years after the
Securities and Exchange Board of India
(
Sebi
) embarked on demarcating the
mutual fund
arena, it is planning to apply a fresh coat of paint. It is rethinking the initial categorisation of mutual funds—an exercise that sought to clearly segregate schemes into distinct categories. The regulator has invited comments on its proposals to redraw the contours of its categorisation framework. Here, we identify the key changes proposed and explore if these will benefit investors or lead to more confusion.
Reining in thematic frenzy
When Sebi first introduced distinct fund categories in 2018, it directed that fund houses offer only one scheme per category. It was to prevent clutter and duplication, which complicates choice for investors. But this rule did not extend to thematic and sector fund categories. Fund houses were granted freedom to launch schemes in this space as they saw fit. And they did exactly that.
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With fresh offerings in traditional market-cap or style-driven fund categories restricted, fund houses have targeted a slew of sectors and themes to whet investors' appetite. Of a total of 180 new fund offers (NFOs) in 2024, 73 were sectoral and thematic funds. The new offerings have ranged from more diversified strategies, targeting broader investible ideas like business cycles, special opportunities and innovation to focused, narrow ideas like defence and manufacturing to tourism and electric vehicles, among others. Portfolios of some of these schemes are not far distinct from the existing offerings by the same fund house. This unchecked proliferation of thematic funds has diluted the very essence of Sebi's original intent—to prevent unnecessary clutter and portfolio overlap in mutual funds.
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Sebi has sought to address this problem by directing that no more than 50% of a new scheme's portfolio overlaps with any of the fund house's existing offerings. This will make fund houses think more deeply before introducing newer themes. Existing funds must also ensure compliance within a year from the date of the final circular. Vidya Bala, Head of Research, Primeinvestor.in, says, 'Sector or thematic funds was the only segment where fund houses enjoyed leeway to offer multiple schemes. But now, this freedom will be curtailed if portfolios start overlapping.'
A research analyst at a mutual fund research entity observes, 'Fund houses were in the habit of offering variants of gimmicky themes driven more by hype rather than any genuine
investment
opportunity.'
Meanwhile, Sebi is also looking at reining in index funds and exchange-traded funds (ETFs)—another area where fund houses have flooded the market with offerings without restraint. A separate framework will be issued for this.
Bigger fund, younger sibling
Interestingly, Sebi is rethinking its onescheme-per-category doctrine.
It has proposed to allow AMCs to introduce an additional scheme in any category, provided the existing scheme in that category has completed five years of operations, and its corpus exceeds Rs.50,000 crore. This additional scheme would have a similar objective, run a similar investment strategy, and have broad features matching those of the existing scheme. The asset management company (AMC) may appoint a separate fund manager for the additional scheme.
So why is Sebi diluting its own diktat? Since the initial categorisation rules were introduced, the size of the market has grown multifold. Combined with the influx of retail money, the asset base of several equity-oriented and hybrid funds has also expanded. Thirteen mutual fund schemes now boast assets under management (AUM) exceeding Rs.50,000 crore, as per Value Research data. The largest, Parag Parikh Flexi Cap, now manages Rs.1.1 lakh crore. Among midand small-cap funds, HDFC Mid Cap runs Rs.84,000 crore while Nippon Small Cap manages Rs.67,000 crore in assets.
Defined investing thresholds not in sync with market realities
Market size and listed universe has expanded considerably,making current predefined market cap limits restrictive.
Some experts contend that size becomes a constraint in certain strategies beyond a point. Performance starts to falter as a fund loses its agility. 'We are seeing a problem of scale coming into play,' insists Santosh Joseph, Managing Director, Germinate Investor Services. 'Deploying incremental money gets tricky in certain strategies. If a Rs.1 lakh crore fund wants to take a 2% position in a small-cap stock, it must buy Rs.2,000 crore worth of stocks of a single company.' Taking such a large position in a smaller company can raise the impact cost for the fund. Invariably, such funds tend to run portfolios with long tails, featuring tiny positions across multiple stocks, especially in mid- and small- cap funds. This can potentially dilute fund returns.
A smaller-sized fund, on the other hand, can take bolder bets and can move in and out of positions with more agility. Some experts reckon that introducing a newer fund with same characteristics will benefit investors. Bala remarks, 'If the newer fund can be managed deftly, there is no reason why it should not be permitted. Investors need more options without the problem of AUM.'
But this relaxation by Sebi comes with a caveat. Upon the launch of the additional scheme, the existing scheme must stop accepting subscriptions. Experts are not convinced this is the right way. 'It should not be mandatory to close the existing scheme to subscriptions. That should be left to the discretion of the asset manager,' says Bala. She also feels that fixing an arbitrary number as upper threshold for scheme AUM is not the answer. If the scheme underperforms, natural outflows will occur. 'Fund houses should be given the freedom to launch the second fund even before the first scheme hits the AUM ceiling, so that the performance of the latter is preserved,' Bala insists.
Larger funds may come with a mini replica
Fund houses may get to launch spinoffs of funds with over Rs.50,000 cr in assets and a 5-year track record.
Some fear this proposal will orphan the older scheme. Mahesh Mirpuri, Founder, InvestMutual, argues, 'Everyone will naturally gravitate to the newer scheme. Meanwhile, if only redemptions happen in the existing scheme, its returns will suffer.' Sebi has proposed allowing a merger in such situations, but the rot may already have crept in by then.
The upside to this move is that the larger scheme would stop bloating, often caused by unchecked inflows in raging markets. This would help the fund manager to stay true to the scheme's label and benefit investors as well. Further, capping the total expense ratio (TER) of the newer scheme at the original scheme's last disclosed TER on its NFO date is a welcome move.
Experts are dismissive of having another scheme simply ape the existing scheme. Sebi suggests that the newer scheme must retain the attributes of the first. This may be to prevent confusion among investors. But some say this restricts the playing field for the fund manager, while investors get robbed of choice of a differentiated strategy within a fund category. For instance, if a fund house already offers a quality-centric mid-cap fund, it may offer a value-biased mid-cap fund. 'Fund houses should be allowed to offer distinct strategies within a category, not simply repeat the same flavour,' observes the mutual fund analyst. Joseph argues, 'The fund house should clarify on what basis it is launching the new fund within a category by differentiating clearly between the two.'
In its consultation paper, Sebi suggested that fund houses may offer both Value and Contra funds, subject to the condition that no more than 50% of the schemes' portfolios would overlap at any point in time. The overlap would be monitored at the time of NFO deployment and subsequently on a semi-annual basis using month-end portfolios. In case of more than permitted overlap, AMC shall rebalance the portfolios within 30 business days.An extension of up to 30 additional business days may be granted by the AMC's Investment Committee. If the deviation continues beyond this period, Sebi has proposed that investors in both schemes be offered an exit option without any exit load.
Lifecycle funds may be introduced
These may be used for targeting specific goals for specified time periods with in-built asset allocation features.
A missed opportunity?
Curiously, Sebi has proposed no changes in its defined investible universe for each sub-category of funds. As it stands, largecap funds invest a chunk of their corpus in the top 100 companies by market cap. Mid-cap funds binge on the next 150 stocks, while small-caps retain focus on the next 250 stocks in market cap. Flexi-cap, largeand-mid, and multi-cap funds allocate assets based on these guidelines. With India's market size expanding rapidly, the existing boundaries are proving too restrictive. For instance, the market capitalisation of the company ranked 100th in 2017 was roughly Rs.30,000 crore. Today, it is Rs.1 trillion. Meanwhile, the 250th-ranked company's market cap has grown from Rs.10,000 crore in 2017 to Rs.34,000 today. The universe of listed companies has also expanded considerably over the years. This market cap expansion has altered the universe of large-, mid- and small-caps, even as the predefined boundaries have remained static. This distorts the fund manager's choice. For instance, a large-cap fund may be compelled to drop a company worth just under Rs.1 trillion from its core universe, as it no longer qualifies as a large-cap. Meanwhile, a midcap fund must hunt within a restrictive arena of Rs.35,000 crore-Rs.1 lakh crore, when the number of mid-sized businesses now extends far beyond this universe.
Industry experts argue that these arbitrary boundaries are leaving fund managers handicapped and must be revisited. Bala argues, 'Before attempting incremental changes to the categorisation framework, the regulator must first address the existing anomalies.' Mirpuri says, 'Restricting funds to such a narrow universe was wrong in the first place. All the money is now chasing a few stocks, potentially creating a bubble. India surely has more than 100 large-caps and 150 mid-caps now.' He suggests allowing some overlap in the investible universe between fund categories. Others are in favour of having more dynamic market cap limits.
Introducing lifecycle funds
Under Sebi's revised framework, mutual fund schemes will remain grouped into five categories—equity, debt, hybrid, solution-oriented, and others. Sub-categories remain unchanged, except for the proposed addition of lifecycle funds and sectoral debt funds.
Lifecycle funds may be offered as solution-oriented, open-ended fund-of-funds (FoFs) with a defined target date. Aimed at specific goals like retirement, marriage, or home purchase, they may come with lockin periods of 10, 15, 20, 25, or 30 years. The underlying asset allocation of the scheme will gradually shift from equity funds to hybrid funds and later to debt funds as the target date nears. Further, a fund house may launch a fresh Lifecycle FoF every five years with a maximum tenure of 30 years. Additionally, as each fund reaches its target date, it may be merged with nearest maturity Lifecycle FoF with consent from the unitholders. Experts reckon these funds could be worth exploring, as they would facilitate goal-based investing with automated rebalancing towards a wide range of financial goals.