Mutual fund reclassification rules: 6 years in, rolling with the best

Even as Sebi's classification norms for MF schemes approach six years of completion, we examine the three-year rolling returns of schemes in the top categories to identify the best performers

October 2017 marked the inception of a new era for the mutual fund (MF) industry. The reclassification norms introduced by the Securities and Exchange Board of India came into effect, prompting the industry to revamp its product portfolio.

The market regulator formulated 36 different scheme categories with clearly defined boundaries, mostly revolving around asset quality, market capitalisation, and asset allocation. The objective was to aid investors in identifying schemes better suited to their needs and risk profiles.

This exercise also helped narrow down the various options within each category and put an end to the practice of launching copycat schemes in the same category. Fund houses with multiple schemes in the same category were compelled to merge them, as the new norms allowed only one scheme per category. These changes streamlined MF offerings and facilitated better comparisons between schemes in the same category to identify the top performers.

As the current scheme categorisation nears completion of six years — a fair period for comparative performance analysis — we scrutinise Value Research data on three-year rolling returns over a three-year period to pinpoint the best performers in popular scheme categories. Over the past six years, key benchmark indices have more than doubled.

Rolling returns are considered superior performance indicators compared to point-to-point returns as they provide a true measure of performance consistency and offer a clear picture of the returns your fund has consistently delivered over the same period.

In addition to returns, we also evaluate the funds’ ability to limit downside risk and participate in market upswings. We include the Sharpe ratio as a performance metric that indicates returns from a risk perspective. The higher the Sharpe ratio, the better the risk-adjusted performance of the scheme.

However, it’s important to remember the vital disclaimer before exploring each of the five categories and their winners: past performance does not guarantee future returns. For this study, we have exclusively considered schemes with a history of more than six years.

Flexicap schemes

Flexicap schemes are often recommended for individuals beginning their mutual fund investment journey, as they offer optimal exposure to stocks in all three market capitalisation (m-cap) segments.

Most of these schemes maintain approximately 60 per cent exposure to largecap stocks and allocate the remainder to mid and smallcaps. This strategy has proven successful, with three schemes delivering over 20 per cent rolling returns, compared to a 17 per cent growth in the S&P BSE 500 TRI. These returns are on a par with those in the midcap category.

Interestingly, the flexicap category was introduced by the regulator only in 2020. However, this segment quickly became the largest equity fund category in early 2023, as many fund houses chose to manage their multicap schemes as flexicap and adjusted their fund names accordingly. As of the end of August, 36 schemes with cumulative assets of Rs 2.8 trillion belonged to the flexicap space.

Flexicap funds are often compared to multicap funds, which also invest across m-caps, with the key difference being that multicap funds are mandated by regulations to invest at least 25 per cent in each of the m-cap categories — largecap, midcap, and smallcap.

In the past year, multicap schemes have maintained an advantage over flexicaps. While the average one-year return of flexicap schemes stands at 19 per cent, multicap schemes have averaged a 24 per cent return.

This difference is primarily due to the relatively higher exposure to smallcap and midcap stocks in multicap portfolios, as fund managers are obliged to allocate a quarter of their corpus to them.

During this period, small and midcap stocks have outperformed largecaps significantly, prompting an increase in new multicap scheme launches.

Largecap funds

The second-largest category, with assets under management (AUM) exceeding Rs 2.6 trillion and 30 schemes vying for the top performer positions, is largecap funds. These schemes must allocate a minimum of 80 per cent of their assets to largecap companies, defined as those ranked from 1 to 100 in terms of full market capitalisation.

However, these schemes have faced challenges in matching the performance of their benchmarks in recent years. The majority of largecap schemes have trailed behind benchmark indices due to various factors, including increased market efficiency, a limited investment universe, higher expense ratios, and other portfolio constraints.

This underperformance is also evident in the three-year rolling returns. When compared to the S&P BSE LargeCap TRI, only two schemes — Canara Robeco Bluechip Equity and Kotak Bluechip — have outperformed. While compared to a corresponding National Stock Exchange benchmark index, a few more schemes have managed to outperform, but the difference remains marginal.

In 2022, 88 per cent of actively managed largecap schemes underperformed the S&P BSE 100, according to a study by S&P Dow Jones Indices. However, in the current financial year (2023-24), a higher number of active largecap funds have generated returns surpassing their benchmarks.

Despite the improved performance, active largecap funds have experienced outflows in recent months. Investors have withdrawn a net total of Rs 5,600 crore from these schemes in the first five months of the current financial year.

During this period, investors have predominantly favoured smallcap and midcap funds. Due to the struggle of active largecap funds to outperform, they also face competition from lower-cost passive schemes, which have seen their AUM increase significantly following the pandemic.

Midcap funds

The midcap category enables investors to invest in emerging largecap companies. This category consists of 29 active schemes, managing a combined total of Rs 2.4 trillion. Midcap schemes are required to allocate nearly two-thirds of their corpus to midcap companies, which are ranked between 101 and 250 in terms of market capitalisation. Unlike largecap funds, the majority of active midcap schemes have outperformed. Their performance is reflective of the fact that even the fifth-ranked scheme, in line with the three-year rolling return, has outperformed the benchmark by over 3 percentage points.

In the past year, certain midcap schemes have delivered impressive returns of up to 35 per cent. This has attracted significant inflows and a surge in investors. The consistent outperformance of midcap schemes compared to their benchmarks is primarily due to a relatively larger investment universe, which enables fund managers to seek out undiscovered opportunities.

However, in recent months, some midcap schemes have delivered subpar performance due to multiple factors, including the underperformance of their largecap allocations and a sharp rally in certain market segments where active fund managers have limited exposure. Active funds are expected to regain their edge once the froth in the midcap space settles.

Among active schemes, there is a wide divergence in performance. In the past year, while the best-performing active scheme delivered a 36 per cent return, the worst performer achieved only a 10 per cent return.

Passive funds have also outperformed many active ones, except for a few exceptions. Funds tracking the Nifty Midcap 50 and Nifty Midcap 100 occupy the top ranks. Only a handful of active schemes — HDFC Mid-Cap Opportunities, Mahindra Manulife Mid Cap, and Taurus Discovery (Midcap) — were able to match the Nifty Midcap 100 to some extent.

Smallcap funds

Smallcap schemes are currently favoured by retail investors, enticed by their strong recent performance. This category boasts some of the top-performing schemes across all categories. All of the top five schemes have delivered returns of 25 per cent or more on a three-year rolling basis, according to data from Value Research. The benchmark S&P BSE SmallCap TRI itself has generated a 23 per cent return.

In line with the performance trend in the midcap space, the performance of small active funds has lagged behind in the past year. Only two active schemes, managed by Quant Mutual Fund (MF) and HDFC MF, have managed to outperform the benchmark Nifty Smallcap 50.

Passive schemes tracking the index have delivered returns of 38 per cent during the period. Among the active schemes, there is a significant variance in performance. While the top performer has delivered a 40 per cent return, the lowest-ranking fund has only managed to deliver a 13 per cent return. This divergence underscores the importance of careful scheme selection, especially when investing in the midcap and smallcap categories.

The substantial returns have attracted significant flows into smallcap funds in recent months, leading to record-high folio additions.

In terms of folios, the smallcap category now ranks as the largest, although it is ranked fourth in terms of assets under management (Rs 1.9 trillion). This highlights their popularity among investors with smaller investment ticket sizes. The strong inflows have driven up smallcap stock prices in recent months, raising concerns about overvaluation.

Some fund houses have even implemented restrictions on flows into this category. Smallcap schemes are required to allocate a minimum of 65 per cent to smallcap companies, those ranked 251 or lower in terms of market capitalisation.

Balanced advantage funds

Balanced advantage funds (BAFs) are the most popular hybrid offering, comprising 29 schemes with Rs 2 trillion in assets under management. This category, which provides fund managers with complete flexibility to shift assets between equity and debt, is considered suitable for investors who prefer to delegate asset allocation decisions to the fund managers.

Since BAFs invest in a combination of equity and debt, their returns are lower than those of pure equity schemes. However, they offer better downside protection. During the pandemic-induced market downturn in 2020, most BAFs were able to limit losses.

Compared to the top five largecap schemes, which declined by an average of 34 per cent between December 23, 2019, and March 23, 2020, the mentioned BAF schemes only fell by an average of 20 per cent.

Notably, there is considerable variation between the schemes, depending on the tax structure and investment framework.

HDFC BAF’s decline was in line with the decline in pure equity schemes, while Sundaram BAF only declined by 6 per cent. The industry anticipates increased interest in this category following changes in debt taxation. It is expected that investors will find it more advantageous to entrust asset allocation decisions to fund managers rather than managing it themselves and incurring higher tax liabilities.

In keeping with their expectations, BAFs have started witnessing higher inflows in the past few months, compared to 2022-23, when investors were net sellers of BAF units in most months.