Categorisation and Rationalisation of Schemes

Before October 2017, a single asset management company could run a dozen equity schemes that, on paper, looked different but in fact chased the same large-cap stocks. An investor comparing two “opportunities funds” from rival houses had no way of knowing whether they were comparing like with like. SEBI's circular on Categorisation and Rationalisation of Mutual Fund Schemes dated 6 October 2017 ended that confusion: every open-ended scheme was forced into one of five broad groups and a closed list of sub-categories, with each AMC ordinarily permitted only one scheme per sub-category. This chapter explains the framework, the market-capitalisation definitions that anchor it, the 2020 multi-cap and flexi-cap recalibration, and the regulatory architecture under the SEBI (Mutual Funds) Regulations, 1996 that makes “true to label” a legal obligation rather than a marketing slogan.

Why rationalisation became necessary

By the mid-2010s the Indian mutual fund industry had grown organically and chaotically. Each AMC marketed schemes under proprietary names — “opportunities fund”, “prudence fund”, “advantage fund” — with no standard meaning. Two schemes carrying identical labels could hold wholly different portfolios, while two schemes with very different names could be near-clones. The investor, who the entire mutual fund regulatory scheme exists to protect, was left unable to compare products or to understand what risk a scheme actually carried.

SEBI's response, after deliberation in the Mutual Fund Advisory Committee (MFAC), was the circular SEBI/HO/IMD/DF3/CIR/P/2017/114 dated 6 October 2017. The stated objectives were three: to bring uniformity in the characteristics of similar schemes across the industry; to standardise scheme categories and the attributes of each category; and to enable investors to evaluate the different options available before taking an informed decision. The exercise was not about restricting innovation — it was about ensuring that a scheme's name and category honestly signalled its investment universe and risk. This is the regulatory idea later compressed into the phrase “true to label”.

Crucially, rationalisation is the enforcement arm of categorisation. Categorisation defines the boxes; rationalisation required existing AMCs to fit their entire scheme bouquet into those boxes, merging, winding up, or repositioning schemes that overlapped. An AMC could ordinarily offer only one scheme per sub-category, eliminating the practice of running multiple near-identical funds to capture more shelf space and distributor commission.

The reform must be read against the backdrop of the regulator's wider consumer-protection mandate. The SEBI Act, 1992 charges the Board with protecting the interests of investors in securities and with regulating the securities market, and a retail investor who cannot tell two products apart is, in a real sense, unprotected. The Mutual Fund Advisory Committee — a standing body of industry, investor and independent voices — recommended that the only durable cure was a binding, standardised taxonomy rather than disclosure tweaks. The 2017 circular thus represents a shift from a disclosure-led model, where the burden of comparison sat on the investor, to a structural model, where the regulator pre-defines the categories so that comparison becomes possible in the first place. That structural choice is what distinguishes Indian scheme categorisation from looser regimes abroad.

The five broad groups

The 2017 circular classified all open-ended schemes into five mutually exclusive groups. Equity schemes invest predominantly in equity and equity-related instruments. Debt schemes invest in fixed-income instruments and are distinguished largely by the duration and credit-risk profile of the underlying portfolio. Hybrid schemes blend equity and debt in defined proportions. Solution-oriented schemes are tied to a goal — retirement or children's needs — and carry a mandatory lock-in. Other schemes capture index funds, exchange-traded funds and fund of funds.

Within these groups SEBI prescribed a fixed menu of sub-categories: equity carries ten (later eleven with the addition of flexi-cap), debt sixteen, hybrid six (AMFI's investor material describes seven after counting balanced advantage/dynamic asset allocation separately), solution-oriented two, and other two. The taxonomy is closed: an AMC cannot invent a category outside this grid, and the defining feature of each sub-category — minimum equity allocation, permitted market-cap exposure, duration band — is itself prescribed. Because the sub-category definition is part of the scheme's fundamental attributes, an AMC cannot quietly drift away from it; any change triggers the unitholder-protection machinery discussed below.

Equity sub-categories

The equity group is the most closely watched because retail flows concentrate here. The originally notified ten sub-categories are: large-cap (minimum 80% in large-cap stocks), large & mid-cap (minimum 35% large-cap and 35% mid-cap), mid-cap (minimum 65% in mid-cap), small-cap (minimum 65% in small-cap), multi-cap, dividend yield, value, contra (an AMC may offer either a value or a contra scheme, not both), focused (maximum 30 stocks), and sectoral/thematic. A separate ELSS sub-category covers equity-linked savings schemes, which carry a statutory three-year lock-in and tax benefit under Section 80C of the Income-tax Act.

Each sub-category mandates a floor of 65% in equity and equity-related instruments — the regulatory threshold below which a scheme cannot call itself an equity fund and loses equity taxation treatment. The genius of the design is that the label now constrains the portfolio: a fund named “large-cap” must keep 80% in the top 100 companies and cannot quietly chase mid-cap momentum to flatter its returns. The role of the asset management company in maintaining these floors, and the trustee's duty to monitor compliance, are explored in the linked chapters.

The interplay among the equity sub-categories repays attention because several of them are defined as much by what they exclude as by what they include. A focused fund is capped at thirty stocks, forcing concentration and therefore higher idiosyncratic risk, and it must disclose whether it focuses on large, mid, small or multi-cap. Value and contra funds pursue opposing or unfashionable bets, and SEBI's express bar on an AMC running both simultaneously prevents a house from straddling the strategy merely to hedge its marketing. Dividend yield funds must predominantly invest in dividend-yielding stocks. Sectoral and thematic funds, by contrast, sacrifice diversification deliberately and are therefore the riskiest equity sub-category, which is precisely why SEBI permits multiple such schemes per AMC — each is honestly narrow. The taxonomy, in short, encodes a risk gradient that an alert investor can read directly off the sub-category name.

Large, mid and small-cap definitions

The equity sub-categories are meaningless without an authoritative definition of what counts as a large, mid or small-cap company. SEBI supplied one in the 2017 framework and it remains the bedrock of the entire equity classification. A large-cap company is one ranked 1st to 100th by full market capitalisation. A mid-cap company is ranked 101st to 250th. A small-cap company is ranked 251st and below.

To prevent each AMC from using its own list, SEBI mandated a single industry-wide ranking. The Association of Mutual Funds in India (AMFI), in consultation with the stock exchanges (NSE, BSE and MSEI), publishes the list of stocks ranked by average full market capitalisation every six months — based on data as on the end of June and December, with the lists effective for the following half-years. Mutual funds must adopt this list as the universe for their schemes within the prescribed transition window. The uniform list ensures that a “mid-cap fund” from any house draws from exactly the same 150 companies, so that comparison across the industry is genuine.

This periodic re-ranking is consequential: a company sliding from rank 100 to 101 migrates from large-cap to mid-cap, and schemes must rebalance to stay within their mandated allocations after the list takes effect. The six-monthly rhythm thus quietly drives portfolio churn across the industry.

Debt sub-categories and risk gradation

The debt group contains sixteen sub-categories, and unlike equity they are gradated principally by duration (interest-rate risk) and by credit profile. The duration-defined sub-categories run from overnight (securities maturing in one day) and liquid (up to 91 days), through ultra-short, low, short, medium, medium-to-long and long-duration funds, each pegged to a Macaulay-duration band. The credit- and issuer-defined sub-categories include corporate bond (minimum 80% in the highest-rated instruments), credit risk (minimum 65% in instruments below the highest rating), banking & PSU, gilt, gilt with 10-year constant duration, dynamic bond, floater and money market.

The 2017 framework standardised the duration bands so that, for the first time, a “short-duration fund” meant the same Macaulay-duration range across every AMC. SEBI later reinforced this with the Potential Risk Class (PRC) matrix, which plots each debt scheme on a grid of maximum interest-rate risk against maximum credit risk — a refinement that built directly on the categorisation logic by making the worst-case risk of a debt scheme legible at a glance.

The debt taxonomy carries a sharper investor-protection edge than equity, because debt schemes are widely treated as safe parking grounds for cash, yet a credit-risk fund chasing yield in low-rated paper can be far more dangerous than its placid name suggests. The categorisation made the trade-off explicit: a fund that wants higher yield must label itself a credit-risk fund and disclose that 65% of its assets sit below the top rating, while a fund that wants to call itself liquid is confined to 91-day instruments. The Franklin Templeton episode discussed later in this chapter — six debt schemes wound up amid an illiquidity crunch — underscored why this gradation matters and why the regulator has progressively tightened both the categorisation and the accompanying risk disclosure for debt products.

Hybrid, solution-oriented and other schemes

The hybrid group blends asset classes in prescribed bands. Conservative hybrid funds hold 10–25% in equity; balanced hybrid and aggressive hybrid sit higher up the equity scale (an AMC may run either a balanced or an aggressive hybrid, not both); dynamic asset allocation / balanced advantage funds vary equity exposure dynamically; multi-asset allocation funds must invest in at least three asset classes with a minimum 10% in each; arbitrage funds exploit cash-futures spreads; and equity savings funds combine equity, arbitrage and debt. AMFI's investor education material counts these as seven sub-categories.

The solution-oriented group has two sub-categories — retirement funds and children's funds — each with a lock-in of at least five years or until the relevant age/retirement. The other group covers index funds/ETFs and fund of funds. Because index/ETF and fund-of-funds products and sectoral/thematic schemes track distinct underlying indices or themes, SEBI permits an AMC to run more than one scheme within these particular sub-categories — a narrow and deliberate exception to the one-scheme-per-sub-category rule.

The one-scheme-per-category rule

The structural core of rationalisation is the restriction that an AMC may offer only one scheme per sub-category. The rule attacks the pre-2017 practice of launching multiple lookalike schemes to maximise shelf presence, fragment investor attention and harvest distributor commissions. By capping each house to a single product per box, SEBI ensured that scheme proliferation could not be used to disguise the absence of genuine differentiation.

The exceptions are principled rather than convenient. Index funds and ETFs may be multiplied because each tracks a different benchmark index. Fund of funds may be multiplied because each invests in a different underlying scheme or asset. Sectoral and thematic schemes may be multiplied because each pursues a distinct sector or theme. In every case the justification is that the products are genuinely distinct in their investment universe — the exception proves the rule that mere re-labelling is not enough.

For existing AMCs, compliance meant a once-in-a-generation rationalisation: merging duplicate schemes, winding up redundant ones, and repositioning others into the new grid. SEBI directed that wherever such an exercise changed a scheme's fundamental attributes, the unitholder-protection process under the Regulations had to be followed, giving investors an exit at NAV without load.

The rule also has a competitive-fairness dimension. Before 2017, a large incumbent house could crowd a distributor's shelf with five overlapping equity schemes, drowning out a smaller rival's single honest product. By limiting every house — incumbent or new — to one scheme per box, rationalisation levelled the shelf and shifted competition from quantity of schemes to quality of management within each category. It is a rare instance of a consumer-protection measure that simultaneously lowers a barrier to entry, and it explains why the framework survived industry lobbying largely intact.

Regulatory basis in the 1996 Regulations

The categorisation circular is not free-floating administrative guidance; it draws its force from the SEBI (Mutual Funds) Regulations, 1996, framed under Section 30 of the SEBI Act, 1992. The duty to keep a scheme true to its stated category is anchored in the concept of fundamental attributes. Regulation 18(15A) directs that the trustees shall ensure no change in the fundamental attributes of a scheme, or in the trust, or in fees and expenses, or any change that would modify the scheme and affect unitholders' interests, is carried out unless a written communication is sent to each unitholder, an advertisement is published in an English national daily and a regional-language newspaper at the head office location, and unitholders are given an option to exit at the prevailing NAV without exit load.

The fundamental-attribute machinery is precisely what converts categorisation from a one-time sorting exercise into a continuing legal constraint. Because a scheme's sub-category — and the asset-allocation floors that define it — form part of its fundamental attributes, an AMC that wishes to migrate a scheme from one sub-category to another (for instance, multi-cap to flexi-cap) must trigger Regulation 18(15A): notice, advertisement, and a no-load exit window. The investment restrictions for schemes are set out in the Seventh Schedule and policed by the trustees, whose constitution and duties are examined in the chapter on the trustee's constitution and duties.

True to label: the 2020 multi-cap recalibration

The most dramatic application of the “true to label” principle came in 2020. SEBI found that many multi-cap schemes, despite a label promising investment across all market capitalisations, were in practice heavily skewed towards large-caps because that maximised liquidity and minimised volatility. The label and the portfolio had drifted apart — the very mischief categorisation was meant to cure.

By circular SEBI/HO/IMD/DF3/CIR/P/2020/172 dated 11 September 2020, SEBI mandated that multi-cap schemes hold a minimum of 25% each in large-cap, mid-cap and small-cap stocks — raising the equity floor effectively to 75%, with the manager retaining discretion over the residual. The industry reacted with alarm, fearing forced buying into illiquid small-caps. SEBI's clarification of 13 September 2020 defused the panic: it stressed that funds had multiple compliant routes — facilitating unitholder switches to other schemes, merging the multi-cap scheme with the AMC's large-cap scheme, or converting it to another category altogether — and that the regulator was not compelling anyone to buy small-caps, only insisting that a scheme be true to its label. Compliance was required by 31 January 2021.

Birth of the flexi-cap category

The 2020 recalibration created a gap. AMCs that genuinely wanted to run a go-anywhere equity scheme without the rigid 25-25-25 split now had nowhere to put it. SEBI answered by introducing an eleventh equity sub-category through circular SEBI/HO/IMD/DF3/CIR/P/2020/228 dated 6 November 2020: the flexi-cap fund. It is defined as an open-ended, dynamic equity scheme that must invest a minimum of 65% in equity and equity-related instruments but is free to allocate across large, mid and small-caps as the manager sees fit, with no minimum split per cap band.

The flexi-cap category is, in effect, what multi-cap used to be before the 25-25-25 mandate. Many AMCs that wished to retain the large-cap tilt of their erstwhile multi-cap schemes simply migrated them to flexi-cap — a change of fundamental attribute that required the Regulation 18(15A) notice and exit window. The episode is a clean illustration of how SEBI uses the categorisation grid as a dynamic instrument: it tightened multi-cap to enforce honesty, then created flexi-cap to preserve genuine flexibility, leaving investors with two clearly distinguished products rather than one ambiguous one.

Rationalisation, winding-up and the Franklin Templeton litigation

Rationalisation sometimes requires not merely repositioning a scheme but winding it up, and the law surrounding winding-up was tested in the most consequential mutual fund litigation of the era. In April 2020 Franklin Templeton, citing redemption pressure and illiquidity in the COVID-stricken debt market, decided to wind up six debt schemes holding over Rs 25,000 crore. Unitholders challenged the process, and the matter reached the Supreme Court in Franklin Templeton Trustee Services (P) Ltd. v. Amruta Garg, 2021 SCC OnLine SC 88.

The pivotal question was the meaning of “consent” under Regulation 18(15)(c), which governs the trustees' decision to wind up a scheme. By its order of 12 February 2021 the Supreme Court held that the consent required is the consent of a majority of the unitholders who participate in the poll, not a majority of all unitholders — a reading that gives the winding-up machinery practical workability while preserving the protective purpose of informing unitholders and giving them a voice. The Court had earlier directed that consent be sought after publication of the winding-up notice, and it dispensed with the separate voting contemplated by Regulation 41, appointing SBI Funds Management to monetise the assets. Although the case concerns winding-up rather than categorisation directly, it illuminates the same statutory architecture — trustee obligations, unitholder consent and exit rights — that underpins every rationalisation exercise that affects a scheme's fundamental attributes.

Compliance, disclosure and ongoing supervision

Categorisation imposes continuing disclosure and supervisory burdens. The scheme information document (SID) must state the sub-category, the mandatory asset-allocation pattern, the benchmark and the riskometer. The riskometer, which SEBI made dynamic and scheme-specific from 2021, must be reviewed monthly and disclosed, so that a debt scheme that quietly increases credit risk cannot keep showing a soothing risk level. These disclosures are the daily, granular counterpart to the structural categorisation grid.

Supervision is layered. The AMC's investment team must keep the portfolio within the mandated floors; the trustees must independently verify compliance and report to SEBI; and SEBI itself monitors through periodic returns and inspections. Where a scheme breaches its allocation — for example, an equity scheme dropping below the 65% equity floor — the AMC must rebalance within the prescribed window or face regulatory action. The interaction between categorisation and the permitted scope of an AMC's activities is examined in the chapter on restrictions on AMC business activities.

Exam significance and analytical themes

For judiciary and CLAT-PG candidates, this topic rewards precision on three fronts. First, the numbers: the five groups, the equity sub-category count (ten, eleven with flexi-cap), the market-cap definitions (1–100, 101–250, 251 onwards), and the multi-cap 25-25-25 floor are all examinable as bare facts. Second, the circular chronology: the foundational 2017 circular, the 11 September 2020 multi-cap mandate, the 13 September 2020 clarification, and the 6 November 2020 flexi-cap introduction form a tight, frequently-tested sequence.

Third, and most rewarding analytically, the doctrinal link between categorisation and the 1996 Regulations: how the sub-category forms part of a scheme's fundamental attributes, how Regulation 18(15A) protects unitholders when those attributes change, and how the Supreme Court in Franklin Templeton Trustee Services (P) Ltd. v. Amruta Garg read the consent requirement for winding up. A candidate who can connect the administrative grid to its statutory and judicial scaffolding — rather than merely reciting sub-categories — demonstrates the integrated understanding examiners reward. The broader market context is set out in the chapter introducing mutual funds in India.