There are 2,043 mutual funds in India, and if you count all the plans, options and variants, investors have 9,680 choices to content with. That's a daunting task. However, it starts to become manageable if there is some kind of a taxonomy that is applicable to fund, i.e., if one could put them into different categories that have different investment usages and characteristics. With such categorisation, investors can first understand which category meets their investment needs and then evaluate only the funds that fit into that category. This way, a big task becomes somewhat more manageable because a vast majority of funds do not have to be evaluated. By definition, for any one investment need, only one or two categories are suitable.
That's the theory. In practice, someone has to do the actual work, and that too on a continuous and consistent basis. In India, that's the specialist (mutual funds research and analysis) role Value Research has played for more than two decades. The purpose of any fund classification system should be to help the investor match his own returns expectations and risk-taking ability with the type of fund that he is going to invest in. Therefore, a good fund classification system should almost entirely be about dividing the full risk-return continuum into bands of different return and risk expectations. Since 1994, the Value Research classification system has done exactly that.
Obviously, the system has not been static. With time, more and more funds and more types of funds have been launched. Not just that, fund companies have worked hard to make their funds unclassifiable. That may sound surprising, but there's a clear commercial reason for this. Once there is a classification system, the primary use of that system is to rate, rank and compare funds within each category. Basic marketing wisdom dictates that fund companies should try and differentiate their products so that they can claim that a fund should be evaluated only by its own claimed characteristics and not by comparing it to any other fund. There's nothing new in this--it's just the de-commoditisation imperative that almost every business needs.
Added to this is the problem of drift in characteristics. Funds can--and often do--change their investment styles to look better. An investor who invested in a large cap fund could find that it has gradually drifted towards a higher risk mid-cap fund. If, for the time being, mid-cap stocks are doing better than large-caps, then such a fund may compare well against other large-caps because it actually is better, because it is a mid-cap fund in the garb of a large cap one. With close to 30 categories, there are almost endless possibilities of such shifts.
However, last year, market regulator SEBI finally set in motion the process to fix most of these issues. It announced some 36 categories into which funds must fit themselves. It also announced limits on how many funds each fund company can have in each category, as well as some norms on fund names that may be misleading.
This has resulted in a great deal of activity and changes that appear to be temporarily confusing for investors. However, down the line, the benefits will be many. There will be an officially-stated category which is based on precisely defined investment characteristics. This means that there can be no doubt as to where a fund belongs and who are the peers it should be compared to. It also means that if you invest into a fund of a particular type, there will be a guarantee that it will remain the same, not just in name but also in fact.
As for the upheavals, that's an inevitable part of this kind of a reform. Fund managers and fund marketers may feel constrained but the change is good for investors. The hardest part will be the fund mergers. Since there's a limit on the number of funds in a given category, similar funds will have to be merged. Some of these are large funds which will become truly huge. Will jumbo funds be harder to manage? That's a complex story and needs a separate discussion.
As for now, investors ought to be pleased that, finally, SEBI has decided to bring some order to the messy universe of Indian mutual funds.
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