With the reclassification of mutual funds, there will be a change not only in basis of arriving at performance ratings by rating agencies, but also in the method of analysis to be adopted by the investors while reviewing the performance of the schemes for making investment decisions.
Following SEBI's reclassification of the mutual fund market in India, there has been a change in the way rating agencies -- whose ratings form an important basis for the investors to make their investment decisions -- rate funds.
Prior to reclassification (the process completed on June 30), there were numerous schemes with similar investment objectives available in the market. In order to scrutinize the performance of the mutual fund, investors relied on the ratings provided by various rating agencies such as Morningstar, Value Research, CRISIL, ICRA, Brickworks etc.
Reclassification has resulted in categorization of schemes basis their investment objective leading to fewer schemes in the market and also change in the name, category, fundamental attributes etc.
However, with the reclassification of mutual funds, there will be a change not only in basis of arriving at performance ratings by rating agencies, but also in the method of analysis to be adopted by the investors while reviewing the performance of the schemes for making investment decisions.
What does the rating reveal?
Ratings act as an indicator of health of the mutual fund, taking into consideration a combination of risk-adjusted performance parameters over various time frames, which are compared against the funds within the same category. Some rating agencies take into account various quantitative and qualitative parameters while evolving the ratings for a fund, such as returns, liquidity, risk-return trade-off, asset concentration, asset quality, corpus size, portfolio turnover, fund managers experience, number of schemes to fund manager ratio, proportion of AUM performance etc.
Different rating agencies often consider contrasting parameters in rating a scheme and arrive at different ratings. This happens due to the difference in weights attached by these agencies to various parameters. Some agencies emphasize on parameters like credit rating of underlying securities and other risk factors, while some agencies rely on past performance for their ratings.
Analyzing the possible scenarios in rating to be taken up post reclassification:
Many of the rating agencies hope to adopt the following methodology:
No change in category: The ratings will remain the same.
Minor changes in category: The rating agencies will apply an average degree of similarity between the current category and the fund’s historical categories.
Major Change in category: In such cases some rating agencies have suggested that where no historical returns of the fund become relevant, then they might suspend the rating till a reasonable period has elapsed after the reclassification.
For the purpose of disclosure of the past performance, SEBI has issued a circular with various possibilities of merger of schemes and the resultant effect of the same. First scenario, schemes A and B having similar features and objective, merge to form A, the surviving scheme. Here the weighted average performance of both the prior schemes needs to be disclosed. Second scenario, schemes A and B merge and the features of only B is retained, then the weighted average performance of only B needs to be disclosed. Third scenario, schemes A and B merge, resulting in the formation of a new scheme C which does not entail the features of schemes A or B.
One of major effects in the third scenario of reclassification is when due to merger of schemes the past performance will not be carried into the new scheme, wherein as a result of merger, there will be little or no data available on performance, which will have to be accumulated over a period of time.
This unpredictability needs to be weighed in by the Investors, who intend to invest or divest from such schemes, as the performance reflection made by the rating agency might not take into account the weighted average performance of the prior schemes, creating uncertainty among the investor group.
Investor guidelines while investing in mutual fund
With reclassification of mutual funds, some schemes have undergone changes in their primary features resulting in skepticism from investors on the ratings provided.
Investors need to collectively analyze the quantitative + qualitative aspects of the fund to understand the changes affecting their investments. If there is a significant change in the investment style and return positioning of the scheme, then the investor needs to analyze the overall impact on their portfolios and also tax implications and exit load impact.
Due to this substantive change in the schemes, rating agencies also believe that they will have to refine their rating methodology which shall bring out the actual performance rating as against just riling on the past performance of the funds. Therefore, it is advisable that a holistic understanding of the realigned schemes must be taken into consideration before making any changes to the respective investor portfolios.The writer is Managing Partner, ARA LAW