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A note on the changes in Value Research Fund Classification

Readers are asking why the Value Research fund classification system is almost, but not perfectly, aligned to the official one


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A couple of months ago, I'd commented that even though regulator SEBI has officially classified mutual funds into 36 categories, individual investors could ignore 32 of them and get by just fine. The idea was that as an individual investor, we have few needs apart from a tax-saver, a short-term substitute for bank FDs that is tax efficient, an equity-debt hybrid fund for the medium term, and an equity fund for the long-term. Really, this is the short alphabet out of which a lifelong story of fabulously successful saving can be woven.

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However, just because investors can opt for this radical simplification does not mean that the mutual fund industry or its regulator is going to do so. The reorganisation of fund and categories has resulted in a lot of activity, but the total number of funds has reduced by just 41, and as I write this page is, coincidentally, exactly 2018. From our perspective as a beginner investor trying to understand what fund investing is all about, that by itself is no progress at all.

There is no way of coping with this complexity except to classify the funds into categories and then, based on one's investing needs, eliminate entire categories from consideration. It must be noted that SEBI hasn't done a reclassification, but a classification. Despite being three decades old, the Indian mutual fund industry has never had a regulated way of classifying the funds. There were just some defacto categories which were a byproduct of the tax laws, and that was it.

However, just because there were no official categories does not mean that investors did not need them, or that no one actually did the work of classifying them. Someone has to do that hard work of classification, and that too on a continuous and consistent basis. In India, that's the specialist mutual funds research and analysis role that Value Research has played for more than two decades.

During this time, we have needed to make plenty of changes to this system. More and more funds of different and new types have been launched. Funds have often changed their investment styles to perform better, or failing that, to just look better or sell better.

However, it's now, after the entire mutual fund industry has settled down to follow SEBI's official playbook, that we have chosen to deviate in some ways from it because we feel that that investors would make better choices this way. In the SEBI system, passively managed funds, like index funds and ETFs, which just follow an index, are a separate category. However, in the Value Research system, each of these funds is part of whichever category it would fall into depending on its portfolio. So, for example, an ETF which follows a large cap index would be classified as a large cap fund in the Value Research system, as opposed to an Index/ETF fund in the official system. The reason is pretty obvious; for real life investors' needs, the prime use of categories is to provide a comparable set of funds for a given purpose. If an investor wants to invest in large-cap funds, then surely a large-cap ETF fund should be compared to other large-cap funds. An ETF category does not serve this purpose at all.

Somewhat similar is the case of a category called 'focused' funds, which SEBI has defined as fitting funds that invested in a maximum of 30 stocks. Clearly, this by itself is not an investing requirement. A fund focused on small-cap stocks emphatically does not serve the same investor need as one focused on large-caps. Therefore, the only structure that serves investors' interests is one where these funds are fitted into wherever their portfolios take them. That's what we have maintained in the Value Research system.

A curious case is that of SEBI's two 'solution-oriented' categories, 'Retirement Fund' and 'Children's Fund'. These are a real puzzle. Money made from any mutual fund can be spent on anything. Nothing prevents an investor from investing in any fund for any need. The best choice is the fund that is most suitable by the universal measures for any investment - returns, liquidity, and safety. Consequently, these 'solution-oriented' categories do not exist at all in the Value Research system.

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