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Mutual Funds - It’s Time to Revise SEBI's Hybrid Fund Category Norms

13 Jul 2020

We have discussed earlier the necessary changes that are required in Securities and Exchange Board of India’s (Sebi) debt fund contour regulations. While the broad market focuses on equity and debt funds, hybrid funds are also relevant. Sometime earlier, there was a lot of discussion about inter-scheme transfers and inferior exposures being allegedly shifted from credit-oriented funds to hybrid funds. In reality, that matter was not what it was made out to be, but that gives a perception that hybrid funds are a distant cousin to mainstream ones. From the perspective of regulation and transparency, all funds are equal. In this backdrop, we discuss the requisite suggested changes to Sebi norms.

There are six hybrid fund categories with various combinations of equity and debt exposure. What are the issues with hybrid fund regulations? The biggest issue is that the definition of portfolio construct is only in terms of percentage allocation to equity and debt. While that is necessary, it is not sufficient. In mainstream equity funds, the definition is as per market capitalization. In mainstream debt funds, it is in terms of portfolio maturity and, in some cases, in terms of credit rating. In hybrid funds, none of these criteria are mentioned in the equity and debt components of the portfolio. An investor getting into a hybrid fund is aware of the debt: equity allocation, but beyond that, she does not know, apart from the latest portfolio disclosure, what the fund manager can or cannot do in the fund. The contours are broad and flexibility to fund managers is good, but the purpose of Sebi’s fund classification norms is to bring about uniformity.

There may be an argument to allow some flexibility to the asset management company (AMC) in portfolio management. In that case, Sebi may delineate certain buckets for the AMC to pick and choose. For example, the equity component being large-cap-oriented or multi-cap or the debt component to be managed in the maturity bracket of, say, two to four years or dynamically, and so on. The investor signing up for the fund will have a perspective on the contours when the AMC declares the portfolio management strategy with more detail. Unfortunately, typical investor behaviour is to look at the last period returns as an influencing factor for the investment decision. The delineation will give some clarity on the strategy the returns have come from.

Moving on, some fine tuning. There is an overlap between dynamic asset allocation or balanced advantage fund category and aggressive hybrid fund category. In dynamic asset allocation funds, defined as “investment in equity or debt managed dynamically", it is possible to run equity allocation in the 65-80% range. Aggressive hybrid funds can have equity allocation in the range of 65-80%. If an AMC runs both funds with a similar mandate, it is legally valid. In a dynamic fund, the fund manager can go short on the equity component, but it is not a compulsion; hence, the two funds may be run on a similar mandate. But the purpose of Sebi guidelines is to ensure that AMCs do not duplicate funds and have only one fund of a given description.

Another aspect of hybrid funds is the corpus volatility in arbitrage funds in recent times. Arbitrage funds earn their returns from the price differential between the price in the equity stock or cash segment and the stock futures segment. This segment is subject to volatility; the spread or price differential moves up and down as per the demand-supply of stock position roll-over and extent of money funding it. Unfortunately, arbitrage funds have been positioned as substitutes for liquid funds in certain quarters, which is not correct. Liquid funds are meant for short-term parking of money. Arbitrage funds are meant for an adequate investment horizon to cover the various market cycles, when the spreads move up or down and are even negative in extreme conditions, which led to the exodus of money in the recent past. Imposition of exit load of, say, six months or one year will lead to discipline as the investor will know that the commitment is for a certain time period and won’t treat it as a liquid fund substitute.

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Mutual Funds - It’s Time to Revise SEBI's Hybrid Fund Category Norms

13 Jul 2020

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