By Hemant Manuj
A recent circular issued by the Securities & Exchange Board of India (SEBI), dealing with the composition of multi-cap schemes, has invited a lot of interest from, and discussion amongst, market participants. This is an important subject for the mutual fund industry.
The circulars issued on September 11, 2020, and subsequently clarified on September 13, 2020, advice the mutual funds to maintain, in their multi-cap schemes, a minimum investment of 75% of total assets in equity and equity-related instruments. It further asks the mutual funds to maintain a minimum of 25% each in large cap, mid cap and small cap companies. These circulars have been issued to achieve two objectives:
True to label schemes: The portfolio should reflect the name of the scheme and the name of the scheme should correctly reflect the nature of the portfolio.
Comparison with an appropriate benchmark: The scheme performance should be disclosed to the investors vis-à-vis an appropriate benchmark.
The objectives are, without doubt, well-intended. A mutual fund has a fiduciary contract with its unit-holders that it will manage their money by investing in a certain set of securities. So, it is important that the promise be stated and monitored in clear terms. SEBI is trying to ensure these principles through the aforementioned circulars.
However, the tools and the process employed by SEBI have scope for improvement. Let us understand how the current mode of classification of the schemes may not be the most appropriate.
Risk and return
A fundamental and universally-accepted concept in investment is that the return from any security is related to the risk in that security. Ironically, investors across the world are so often misinformed, and products are mis-sold, ignoring this fundamental tenet. Likewise, investors in a mutual fund are also communicated mostly on the likely returns, but not much about the risks on their investments.
Currently, the equity mutual fund schemes are classified on the basis of the market capitalisation of their underlying stocks. This begs the question: Whether the names of the schemes on the lines of large, mid or small caps convey the risk fully?
There has been a lot of research over the decades to capture the relationship between risk and expected return from stocks. The three-factor model by Fama and French (1993) and the four-factor model by Carhart (1997) have demonstrated size, price-to-book ratio, and momentum, apart from beta, as the explanatory factors for expected return from a portfolio. Thus, the size of underlying stocks in a scheme is only one of the factors determining the risk in it.
If this is the case, what can we do to provide more meaningful information to investors?
Simple and meaningful disclosures
I suggest a simple approach. A mutual fund may be allowed to choose its portfolio allocation in the scheme without any restrictions on size. It should, however, disclose the following, regarding the scheme:
(a) The total risk, rather than proxy measures like large cap, mid cap or small cap. SEBI may choose to mandate an appropriate risk measure like the annualised standard deviation for the portfolio.
(b) The expected risk-adjusted return. This may be a ratio like the Sharpe ratio.
A mutual fund may invest in any stock from large, mid or small cap category, up to 100% of its portfolio. Similarly, it may invest in growth or value stocks to any extent. The mutual fund would be required to disclose upfront the risk and the risk-adjusted return for its planned portfolio. For this, it would run simulations of its potential portfolio with multiple combinations of risk factors, thereby computing the standard deviation and the expected Sharpe ratio. One year later, the mutual fund would again be disclosing the actual values of standard deviation and the Sharpe ratio achieved in the scheme. These figures should be compared with the figures disclosed ex ante.
The benefits of adopting the above approach are as follows:
(a) Investors will receive a simpler and better estimate of the true risk, rather than only one dimension of the same.
(b) The performance of all the schemes can be better measured because it would have announced, in advance, the specific levels of risk and risk-adjusted return targeted by it.
(c) The mutual funds will be incentivised, upfront, to disclose the risk closer to what they really believe to be true. As a result, the chances of mis-selling of products will be minimised.
(d) The monitoring of various individual dimensions of risk like size of stocks, sectors, etc, can be done away with. This will reduce the cost of compliance for the mutual fund and monitoring by the regulator and investors.
The way forward
Currently, the mutual funds do publish their portfolios and returns, therefrom, monthly. They may now be also asked to publish the standard deviation and the Sharpe ratio, historical (actual) and forward-looking (expected), monthly. The historical figures are, in fact, already being computed and published by various investment advisors.
In summary, SEBI need not prescribe any threshold of securities in which the mutual funds may invest.
It has a larger role to play in minimising information symmetry through adequate and meaningful disclosures. At the same time, it should establish a framework that provides the right set of incentives for the mutual funds as well as investors to make informed decisions. The purpose here is to lead a debate on making disclosures by the mutual funds more meaningful and transparent.
The author is associate professor & area head, Finance at Bhavan’s SPJIMR