How the Two-Tier Benchmark Rule Helps Investors

The two-tier benchmarking framework mandated for mutual funds by the Securities and Exchange Board of India (Sebi) last October, will reinforce the Potential Risk Class (PRC) matrix introduced in December. This will help investors better compare funds before investing.

While the new benchmarking guidelines apply to all categories of mutual funds, recent changes would be particularly helpful in capturing the granular risk elements of debt mutual funds.

To understand the changes, let’s start with a brief overview of the PRC matrix.

Decoded matrix

The PRC is a 3×3 matrix that shows the maximum risk a mutual fund will take in terms of credit and interest rates. Credit risk is classified into three categories—classes A, B and C—based on the risk-weighted value of each instrument granted by the regulator.

Interest rate risk, on the other hand, is measured in three blocks – classes I, II and III – using Macaulay duration.

Asset management companies are required to place their systems in the PRC grid so that investors understand the maximum risk associated with them.

If a scheme takes on a higher risk than indicated by the PRC tranche it is placed in, this implies a change in its fundamental attribute, thereby allowing investors to exit the scheme without incurring an exit charge.

In line with these guidelines, mutual funds have started to include a risk meter to show the risk associated with the program and the PRC to show the maximum risk.

However, mutual funds also continued to benchmark their plans against indices representing that plan’s category. For example, a short-term fund was compared to the CRISIL Short Term Bond Fund Index, which may not have a credit allocation similar to the plan or the plan’s PRC.

Benefit of benchmarking

The new two-tier benchmarking rules help solve this problem. The level 1 benchmark indicates to the investor which risk matrix is ​​followed by the debt fund, while the level 2 index reveals the strategy adopted by the latter vis-à-vis the definition of the category, thereby highlighting any style deviations.

In addition, comparison with the Tier 1 benchmark can help investors assess the effectiveness of the fund manager’s strategy within the category and PRC tranche.

The Level 2 benchmark which should more closely represent the fund’s strategy can help investors assess the alpha relative to the targeted strategy adopted by the fund.

So far, only a small number of schemes in the domestic mutual fund industry have reported their Tier 2 benchmarks as these are not mandatory.

However, the benefits are there for everyone. For example, a fund in the very short-term funds category that follows a more liquid portfolio strategy aligned with liquid funds and has identified the liquid funds benchmark as its level 2 benchmark.

Similarly, some funds in the corporate bond fund category have identified the AAA short-duration bond index as their level 2 index, in line with their investment strategy of investing in short-dated first order. Another fund in the category of bank funds and PSU selected the benchmark for the roll-down strategy in accordance with its strategy.

To reiterate, therefore, the two-tier benchmark structure should further improve disclosures in the mutual fund industry.

Mapping the risk of debt funds with the PRC will also allow for better comparison of funds within a single category, instead of comparing all funds in the set of peers on the same metric – grouping can now be done based on Level 1 and Level 2 benchmarks.

That said, individual earthworks remain more critical than ever for investors. For example, while the PRC matrix will present the maximum risk a plan could take, the fund manager may choose not to invest up to the thresholds.

Thus, the classification based on the matrix only serves as a guide. It is important that investors review these parameters in conjunction with their own due diligence on the plan’s portfolio.

Piyush Gupta, Director, Fund Research, CRISIL.

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