Expert advice

Sep 20, 2013,22.04 IST

SEBI colour coding norms on mutual funds demystified!

Dr.Renu Pothen

On March 18, 2013, the Securities and Exchange Board of India (SEBI) came out with a regulation which made it mandatory for fund houses to start labeling funds on the basis of 3 parameters: nature of scheme, investment objective and level of risk, denoted by 3 different colours.

This was done to address the issue of mis-selling in mutual funds and also to provide investors an easy understanding of the scheme that they are investing in and its suitability to them.

The aim of my column is to focus on the SEBI diktat relating to product labeling on the basis of colours, how fund houses have actually implemented this across the huge spectrum of  funds and finally, my take on if there is more to the colours than what this regulation actually implies.

As per the SEBI regulation, the level of risk will be depicted by the colour code boxes:

Blue: Principal at low risk

Yellow: Principal at medium risk

Brown: Principal at high risk

This regulation came into effect on July 1, 2013 post which all the fund houses have labeled their funds on the basis of the risk levels.

My Observations on Product Labeling:

All categories of equity funds, both domestic and global, have been labeled as brown. As for debt funds, there is a variation as a majority of the fund houses have labeled them as blue while a few of them have labeled this category of funds as yellow .

An interesting observation here is that some of the fund houses, which are known to be very aggressive in their investment strategies, have actually labeled their debt funds as blue whereas conservative players in the industry have labeled this category as yellow.

For funds in the hybrid category like balanced funds and Monthly Income Plans (MIPs), the former is being categorized as both a high and medium risk product (brown and yellow colour), while the latter is considered a medium-risk product with all the fund houses assigning a yellow colour to this category of funds.

My Take:

Fund houses labeling the same category of funds in different colours is actually sending out wrong signals to investors. For instance, if a short-term fund is labeled as blue and yellow by two fund houses and if both of them have the same portfolios, then what inference should the investor derive after seeing this categorization?

Another flaw in product labeling is that all categories of funds in equity or debt are labeled as just brown or blue. As far as equity funds are concerned; mid-cap, value and contra, and sector funds carry much more risk than plain, vanilla large-cap funds.

In the same way, for fixed income, duration funds will be riskier than liquid, ultra short-term or even short-term funds. In this scenario, I think the fund houses should try to bring some uniformity when they colour code their funds to bring in some sanity to this entire exercise.

As far as investors are concerned, they must bear in mind that when mutual funds are labeled on the basis of colours, they definitely carry an element of risk and investors should be prepared to go through this short-term volatility.

At this juncture, it is wise to remember that after 15 days of implementation of this regulation, all liquid funds and ultra short-term funds, which are considered to be the safest instruments in the industry, went into the negative territory on account of measures taken by the Reserve Bank of India (RBI) to tame currency volatility.

This led to a lot of panic among investors, all of who then reminisced about their parents and grandparents who relied solely on fixed deposits (FDs) to meet the financial goals in their life.

I am not refuting the fact that FDs are even today the safest bet available in the market; however the returns generated by this instrument will not be able to beat inflation and will not be enough to meet our future financial goals.

Hence, investors should take an exposure into mutual funds and simultaneously be ready to face any volatility keeping in mind that these short-term blips will even out in the long term and will aid us in meeting our investment objectives in the long run.

The author is a Research Head at India.

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