[Rudraksh Sharma and Ayush Raj are 4th year students of the B.S.W. LL.B. and B.A. LL.B. programmes, respectively, at Gujarat National Law University.]
India’s mutual fund industry has grown enormously, now exceeding ₹55 lakh crore in assets, prompting Securities and Exchange Board of India (SEBI) to propose an updated categorization framework. On July 18 2025, SEBI released a consultation paper titled “Categorization and Rationalization of Mutual Fund Schemes”, revising the framework first established by its October 2017 and November 2020 circulars. The draft aims to improve transparency and investor clarity by enforcing standardized scheme names, stricter investment mandates, and restrictions on overlapping portfolios. It also permits new scheme types and uses of emerging asset classes — like Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), gold/silver Exchange Traded Funds (ETFs) — as “residual” investments. Overall, SEBI aims to foster product innovation within defined parameters, reduce duplicate schemes, and improve investor clarity.
Evolution of Fund Categorization
SEBI’s October 2017 circular introduced the first major scheme categorization framework, grouping mutual funds into five broad categories: Equity, Debt, Hybrid, Solution-Oriented, and Other. It set precise definitions, mandated minimum allocations and prescribed “one scheme per category per Asset Management Company (AMC)”, except for index funds/ETFs, Fund of Funds (FOFs), and sectoral/thematic funds. Additionally, it mandated the schemes to rebalance their portfolios semi‑annually to the large/mid/small‑cap lists published by the Association of Mutual Funds in India’s(AMFI).
The November 2020 circular eased certain constraints, notably introducing the Flexi Cap category, which permitted allocation across market capitalizations without fixed thresholds. It also allowed AMCs to offer both value and contra funds, increased the threshold defining large-cap companies, and reaffirmed the “true-to-label” requirement, ensuring alignment between a scheme’s portfolio with its stated investment strategy. Despite these reforms, growth in thematic and sectoral funds led to significant portfolio overlaps, weakening scheme differentiation and increasing to investor confusion.
The 2025 draft consolidates and updates the prior guidelines under a Master Circular. Key revisions include stricter equity thresholds — e.g., Multi-Cap funds must now invest 75% in equity (up from 65%), and the Large Cap funds must hold 80% in top-100 stocks. These changes underscore SEBI’s intent to ensure that the fund names accurately reflect the underlying investments. In sum, the 2025 draft builds on past rules but allows more nuance, implicitly admitting that the earlier “one-scheme-per-category” rule no longer fits the industry’s size.
Portfolio Overlap Restrictions
A central objective of the draft is to limit portfolio overlap between schemes that seemingly serve similar mandates. SEBI notes that many AMCs had created near-duplicate funds — especially in thematic and equity sub-categories — thereby diluting choice. To address this, the draft proposes that no two schemes in certain related categories may overlap by more than 50% of their portfolios. In practice, this means SEBI would allow an AMC to offer both a Value fund and a Contra fund only if their portfolio overlap does not exceed 50%. If it does, the AMC must rebalance within 30 business days, extendable by another 30 days with its Investment Committee’s approval. Persistent breaches would trigger an automatic, no load exit option for investors of both schemes. Overlap will be checked at the New Fund Offer (NFO) stage and then reviewed semi-annually using month-end portfolios.
This 50% cap also applies to thematic and sectoral equity funds (excluding large-cap funds), requiring that no new fund in these categories shares more than 50% of its portfolio with an existing scheme. Existing thematic/sector funds will have one year from the final circular to comply with this limit.
The draft also permits sector- or theme-specific debt funds (e.g. “Infrastructure Bond Fund”), provided their portfolio overlaps no more than 60% with any other debt scheme at the AMC. Further, this is contingent on there being enough high-quality bonds in the chosen sector, and it even exempts these new sector-bond funds from the usual sector-wise exposure cap (Clause 12.9.1 of the Debt MF Master Circular) so long as overlap and credit quality norms are met.
These overlap rules mark a significant change from 2017/2020 circulars, where no explicit numerical overlap limit was set. By prescribing a brightline 50% (or 60%) threshold, SEBI forces AMCs to differentiate their schemes’ portfolios. While this may enhance product clarity and limit the proliferation of redundant funds, it also introduces compliance complexity and raises practical questions—such as whether overlap should be measured by market value, number of common holdings, or both.
Investment Flexibility – “Residual” Portions and New Assets
The draft introduces a new concept of a “residual portion” within a scheme’s portfolio. For each category, SEBI defines a primary asset class and permits the remainder to be invested in other asset types, subject to existing overall limits. For equity schemes, the non-primary portion maybe be invested into debt securities, gold and silver funds/ETFs, and in REITs/InvITs. SEBI notes this gives portfolio managers flexibility to manage liquidity and risk, while staying within overall asset-class limits under the MF Regulations.
This framework extends to other categories. For debt schemes, extra cash beyond the fund’s intended duration bucket may be parked in REITs/InvITs, except for ultra-short duration schemes like overnight, liquid, ultra-short and low-duration funds, which remain highly liquid and are barred from illiquid assets. For hybrid schemes, other than arbitrage or dynamic asset-allocation funds, leftover cash can similarly go into REITs/InvIT. Solution‑oriented funds (retirement or children’s funds) may use REITs/InvITs for residual portfolios, except in the retirement/children’s hybrid variants.
This marks a shift from the earlier regime, where an “equity fund” could mostly hold equity and cash/bonds for diversification/liquidity, and hybrid funds were limited to equity and debt. The revised approach invites use of newer instruments—such as REITs, InvITs, and commodity ETFs—within the residual allocation. These assets offer alternative tools for managing liquidity and risk; for instance, during market downturns, an equity fund experiencing a cash drag may allocate residual capital to REITs instead of overnight instruments.
In practice, allowing REITs/InvITs/gold across categories may blur the traditional lines. SEBI keeps the core equity or debt percentages high while mandating caps for and any residual exposure, ensuring continued transparency. The move reflects market evolution as new asset classes are now mainstream and industry is seeking more leeway. Such industry representations are also noted in the SEBI’s consultation paper, acknowledging the need for “flexibility for product innovation” while maintaining investor protection and scheme clarity. That said, the effectiveness of this reform will hinge on how clearly the definition and limits of “residual” investments are enforced.
Conclusion
SEBI’s draft circular marks a meaningful step in India’s mutual fund regulatory framework evolution as it proposes an approach to scheme categorization that is more flexible but also more standardized. It enables portfolio innovation—such as the inclusion of REITs, InvITs, and commodity ETFs—while reinforcing transparency, stricter investment mandates, and clear scheme naming to prevent duplication and mis-selling. By encouraging product diversification and responsiveness to investor needs, the draft reflects SEBI’s continued focus on market discipline and investor protection. However, in order to prevent mis-selling and to ensure wise risk management is not sacrificed for increased flexibility, SEBI must carefully monitor the implementation. If executed thoroughly, the reforms could deepen India’s capital markets and improve investor trust, which can also position mutual funds for a new phase of sustainable growth.
– Rudraksh Sharma and Ayush Raj