20/25 Rule In Mutual Funds Explained

Individual investors (or a small group of investors) holding substantial portions of units in mutual fund schemes can potentially create concentration risks and compromise the collective investment nature of mutual funds.

To curb this practice, the Securities and Exchange Board of India (SEBI) established what is commonly known as the "20-25 rule" for mutual fund schemes in India. This rule aims to ensure proper diversification of schemes and mitigates concentration risk at the outset.

While the 20/25 rule is mandatory for mutual fund companies, it can also serve as a helpful guideline for retail investors. Read on to learn more about the 20/25 rule and how it seeks to ensure diversification and protect investor interests in India.

• Table of contents

• How to use the 20/25 rule for mutual fund investments?
• What is the importance of the 20/25 rule?
• What are the potential advantages of following the 20/25 rule?

How to use the 20/25 rule for mutual fund investments?

The 20/25 rule for mutual funds is a practical guideline established to promote effective diversification in investment portfolios.

The fundamental principle of the 20-25 rule is twofold

• Each scheme and individual plan under the schemes must have a minimum of 20 investors.
• No single investor should account for more than 25% of the corpus of such scheme/plan.

These requirements aim to ensure proper diversification of investor base and prevent concentration of ownership, which aligns with the very essence of mutual funds as vehicles for collective investments.

Rather than being a rigid strategy, the 20/25 rule serves as a framework to help investors maintain a well-balanced portfolio while avoiding excessive concentration in particular funds or sectors.

Also Read: What Is 75-5-10 Rule

What is the importance of the 20/25 rule?

The 20/25 rule serves dual importance in the mutual fund industry.

From a regulatory perspective, it mandates that each mutual fund scheme must have a minimum of 20 investors, with no single investor holding more than 25% of the scheme's corpus. This rule prevents concentration risk and maintains the collective investment character of mutual funds, protecting smaller investors from potential market manipulation by large investors.

What are the potential advantages of following the 20/25 rule?

It reduces concentration risk by ensuring that a single investor cannot dominate the fund’s assets. This protects the interests of smaller investors and maintains the stability of the scheme, as large redemptions by a single investor will not destabilise the fund.

The rule also encourages diversification, both in terms of the investor base and the underlying assets. By mandating a minimum number of investors, the rule helps prevent overreliance on a few large participants, which can make the fund more resilient to market shocks and investor exits.

For the portfolio itself, this also typically translates to better diversification of investments, as funds are incentivised to spread their holdings to attract a broader investor base. Thus, the 20/25 rule promotes transparency and fairness in mutual fund operations. It prevents undue influence from large investors over fund management decisions, thereby fostering a more equitable environment for all participants

Conclusion

The 20/25 rule's implementation across new and existing schemes, with appropriate transition periods and exemptions, demonstrated SEBI's balanced approach to regulation. The ongoing compliance requirements and reporting mechanisms have created a sustainable framework for monitoring and enforcement. Over the years, this rule has become an integral part of mutual fund operations in India, contributing to the industry's growth and stability.

FAQs:

Is the 20/25 rule suitable for all types of investors?

The 20/25 rule is a mandatory SEBI regulation for mutual fund schemes, not an optional guideline. Regardless of investor preferences or suitability, all mutual fund schemes must comply with this rule - maintaining a minimum of 20 investors with no single investor holding more than 25% of the corpus.

Can the 20/25 rule be adapted to changing market conditions?

The 20/25 rule is a mandated SEBI requirement for mutual fund schemes, not an option. While individual investors may have different preferences regarding portfolio construction, mutual fund companies have no choice but to adhere to this regulation.

Are there variations or alternatives to the 20/25 rule in mutual fund investing?

While there are other SEBI regulations governing mutual funds (such as sector exposure limits of 25% and single company exposure limits of 10%), these are separate rules addressing different aspects of mutual fund management, not alternatives to the 20/25 investor concentration rule.