Mutual Funds 2018 – 5 big changes for investors

Year 2018 has been an action full year for mutual funds – the fund houses as well as investors. For the industry and the fund houses, it was all about size and volume. Assets under Management or AUM reached the highest at Rs. 24 lakh crores and the markets peaked, with more of you putting money via mutual funds.

For the first time ever, in Dec 2018, MFs are managing more money in stocks than the insurance companies. (Source)

Well, there is the other side too. ICICI MF was caught with a crutch to a group company IPO – ICICI Securities. IL&FS debacle and the way it impacted debt funds, is still fresh & hurting in the minds.

Actually, 2018 was more about the common investor in mutual funds. SEBI made several pro investor moves with an aim to make MF investing transparent and simpler. Finally, there was the tax bite in Budget 2018.

Together, these changes forced several mutual fund investors to take a critical look at their portfolios and restructure them to align with the new reality.

Now, let’s revisit some of the big changes of the year.

#1 SEBI Scheme Recategorisation

One of the key changes brought about by the regulator was to make MF schemes more understandable to a lay investor through predefined categories. Any MF scheme has to be in one of these categories and only 1 fund scheme can be in any category for open-ended funds. Each of these categories have a unique universe and / or investment mandate.

Initially, it was hailed as a great decision with the hope that several lookalike schemes from the MF jungle will vanish making choice easier.

Well, investors were left deeply disappointed as some of the largest fund houses with their entire marketing wisdom and cunning craft got to retain almost all of their schemes. Not just that, now to fill the buckets where they had no scheme, they launched new ones.

Let us not forget that closed ended funds (where the new rules don’t apply) can still be launched without any limits and that’s what we saw too – a spate of launches of closed ended funds.

In a competitive market, you cannot afford to not be in a category showcase. Mutual Funds are quite akin to FMCG business.

Finally, instead of having less, we are now staring at more well defined schemes and more confusion. See the irony!

Not just that there were some senseless scheme mergers too, which made sense only to the accounting and marketing teams, none to the investor. Take for example, the mergers of HDFC Balanced Fund and HDFC Prudence Fund into smaller schemes, respectively.

All in the quest of reducing the base NAV so that more gullible investors can be targeted.

Thankfully, some of the smaller and niche fund houses chose to stay away from this madness and continue to focus on the most important thing – fund management and customer service.

As an investor, you have to now watch out because most schemes are now working with new universes. Their flexibility is constrained unlike in the past. Past performance is redundant. All ratings and rankings can now go for a toss.

For example, if you are planning to buy a predominantly large cap fund such as ABSL Frontline Equity, which has its universe as BSE 200, know that the universe of the fund is now BSE 100, a smaller one.

#2 Transparency on expenses and cheaper mutual funds

The expense ratio was typically a blackbox on a day to day basis with the fund house declaring only the end of the month TER in its factsheet.

SEBI now mandated a Daily TER disclosure. Every time, the fund scheme’s expense ratio changes, it will be communicated to the investors as also put up on its website. That makes them more observable.  I am sure you have been receiving emails from your fund houses about change / update in TERs of your schemes.

Again on the expenses, some fund houses were subsidising regular plan commission expenses via Direct plans, using earnings (via all plans) to pay extra commissions. (You can hear different views about this)

SEBI now has mandated that any commission payout has to happen from within the regular plan expenses. There can be no other payout in any form. The difference between direct & regular expense ratio will now only be the difference of commissions.

This led to a wonderful outcome. The direct plan ratios of some of the most well known funds, including some of your preferred ones, dropped. Did you notice?

There is more. From April 1, 2019, the revised slab based expense ratios will also come into effect, further lowering the total expense ratio for fund schemes.

For those investing by themselves via direct plans and others using fee based advisory to draw & manage their portfolios, this is great news. Now, let your advisor deliver full value to you even as he charges a fee.

#3 Total Return Index (TRI) Benchmarking

All actively managed mutual fund schemes exist to produce extra returns (alpha), that is, more than what a market benchmark can give.

If you have been carefully observing the factsheets or online mutual fund sites, comparison of fund performance was typically done with respective index they chose. This performance was limited only to the price movement of the index.

For example, a one year performance of Nifty index would be simply be a difference of the price quote of Nifty as on Dec 21, 2019 vs Nifty as on Dec 21, 2018.

A big problem with this approach was that it ignored dividends that companies might send your way, as also any bonuses. A price index does not capture them. Yet the fact is that when you invest in stock of companies, you can benefit not only from the price but also the dividends and bonuses that they pay. This enhances your total return.

The mutual fund price based index benchmarks were ignoring this additional return and thus showcasing incorrect alpha.

In the wake of this, another important and meaningful measure taken by SEBI was to ensure that the fund schemes are benchmarked against the TRI only or the Total Return Index and not the price index.

The exception is Quantum Long Term Equity Fund, which has been benchmarking itself against Sensex TRI, from day 1. Earlier this year, DSP MF too started TRI benchmarking, before the SEBI mandated all funds.

For an investor, a much better way is to make comparisons between a fund scheme and an index fund (not the benchmark but a working index fund), because these funds can reflect a true market driven performance adjusted for dividends, bonuses and costs.   

This will now put pressure on fund houses. A fund scheme that shows a 1 to 2% alpha in comparison with the price index, may suddenly find itself out of favour with investors.

Investors are sitting up to take notice.  In fact, this has kindled yet another debate amongst investors – is passive investing via index funds/ ETFs better than active?

The whole point of active fund management is to be able to use expertise to build a portfolio that can beat a specified benchmark. If not, investors will be happy with a passive fund, with no manager cost loading. Pure savings in costs would deliver more returns, is what some passive investors believe.

Fund houses too are aware of changing investing preferences and trends. Their response is quite simple.

A spate of of index fund and ETF launches in this year to meet the new demand. It is interesting to note that fund houses are now going gaga over index funds and ETFs and how they are better than alpha chasing actively managed funds.

Not sure how to put it – foot on the axe or axe on the foot?

#4 Sidepocketing

The IL&FS credit rating downgrade / defaults had a massive impact across the debt markets particularly in some of the mutual funds which were holding IL&FS securities. NAVs dropped first and then investors’ jaws too.

The fund houses were caught napping on this one specially in cases where IL&FS securities were part of the liquid and ultra short term funds, usually considered safer than other categories. How could they take such a risk? What was their own assessment before making the investment?

Read more about it here – Safety, taxation, returns – a refresher on debt funds.

The retail investors suffered, some even bailing themselves out with whatever they could. Well, nothing much can be done about what has happened.

SEBI’s solution to this problem is Side Pocketing. What does it mean?

Basically, if there is a holding in a debt fund which suffers a fate such as IL&FS, it can be put aside in a separate pocket so that existing investors don’t suffer. As and when the investment recovers, the existing investors of that time in the fund would receive an additional benefit.

This does not mean that you start chasing alpha in liquid funds too. It is important that you choose your investment schemes carefully and don’t get attracted by additional returns when safety is paramount.

#5  Tax Returns

Probably the most dramatic step was delivered in the Budget 2018 with the introduction of long term capital gains tax.

The long term capital gains tax returned for equity and mutual funds, which were so far exempt for it. If you now sell your investment after 1 year of holding then gains over Rs 1 lakh will be taxed at 10% + surcharge.

However, the silver lining is that all gains till Jan 31, 2018 are exempt. The grandfathering clause takes care of that. Read all about it here

Additionally, you can use your long term capital losses to square off your long term capital gains.

Not just capital gains, even dividends distributed by equity funds are now subject to a tax of 10% + surcharge. And there are no exemptions here. This makes it worse than capital gains.

Investors will be served well to not fall for dividends (your bankers will be after you to sell such funds). At any rate, dividends is your own money coming back to you.

So, these are the 5 big changes of the year 2018 paving way for a safer, transparent mutual fund investing experience.

Come 2019, you have a better chance to build focused portfolio as you work on it yourself or with your advisor.

What is your view on the various changes made? What changes would you like to see next?