Decoding SEBI’s Mutual Fund Categorisation Norms - II : Understanding Lifecycle Funds

In last week's post, I touched upon the major reforms brought in by the SEBI circular released on February 26th 2026. At the end of that article I had promised a separate article on lifecycle funds. I had promised to explain the structure, advertised benefits and potential risks of such funds. In line with that promise, this article is going to delve deep into the subject of lifecycle funds.

Fundamental Concept

Lifecycle funds are largely similar to target date funds. These are open ended funds. They are based on the concept of lifecycle asset allocation. They have defined maturities of 5 to 30 years. They also offer a preset glide path for asset allocation. This means the equity allocation in the fund would progressively reduce as the goal comes closer to falling due. Such funds have therefore been advertised as an ideal option for investors looking to follow a goal based approach to investing.

Let us now understand the advertised benefits by lifecycle funds.

Rule Based Asset Allocation And Tax Free Rebalancing

The fact that lifecycle funds follow a glide path means that asset allocation gets automated. The asset allocation schedule for varying residual maturities of a 30 year lifecycle fund are laid out below. Residual maturity refers to the number of years left before a lifecycle fund matures.

There is clearly a progressive reduction in the equity allocation as the fund draws closer to maturity. The rebalancing exercise is carried out within the fund. This means that investors would not be taxed on any capital gains that arise as a result of rebalancing. This would be a boon for investors who cannot constantly track and manage their portfolios. It also works around the aversion that most investors display with regard to rebalancing their portfolios. Over a 30 year horizon, the costs saved on rebalancing would likely add significantly to the ultimate return generated.

The Arbitrage Advantage

To be classified as an equity fund, a mutual fund must hold at least 65% of its assets in domestic equity. Equity funds offer a favourable tax treatment. LTCG from equity investments are taxed at 12.5% (as opposed to slab rates for gains debt investments). But running an allocation of 65% to equity would be risky when the goal is less than 5 years away.

SEBI allows lifecycle funds to hold upto 50% of assets in equity arbitrage when it has less than 5 years until maturity. I have touched upon arbitrage funds and how they are impacted by the recent SEBI circular in last week's post. The arbitrage allocation would drastically reduce equity exposure within the fund. But the fund would still qualify as an equity fund for taxation purposes. This is an ingenious way to protect the corpus built up within a lifecycle fund close to maturity.

But for all its apparent benefits, some aspects of lifecycle funds do carry cause for concern. These may be overlooked or not properly understood. It is therefore important to take cognisance of them.

No Clarity On Composition Of Equity Allocation

SEBI guidelines specify the exact allocations lifecycle funds are required to maintain towards equity and debt. But there are no such regulations for the composition within each asset class. This is especially risky when it comes to the equity allocation. The fund manager can simply choose to use index funds for the entirety of the equity component.

But they can also choose to park the equity component in highly volatile mid and small cap stocks. One could argue that doing this makes sense if there are 15-30 years left until maturity. It is a viable argument purely from the standpoint of the time horizon. But most of today's investors are recent entrants to the markets.

A large number of them are likely to have entered during the past 5 years. It is unlikely that they would have seen a genuine crash in mid and small caps. It is therefore likely that they would not continue investing in lifecycle funds through a crash. Allocating money to mid and small caps as the residual maturity reduces would also be dangerous. Both of these would defeat the core purpose of lifecycle funds.

Room For Interest Rate Risk Within The Debt Component

SEBI guidelines specify that the debt component of lifecycle funds must be parked in instruments rated AA+ or higher. This mitigates credit risk. But there is no clarity on the tenure of instruments that can be used for the debt component. This creates scope for lifecycle funds to hold debt instruments with long tenures.

In other words lifecycle funds can for instance hold 5 or 10 bonds that are rated AA or higher. Debt instruments with longer tenures are more sensitive to changes in interest rates. This allows for the existence of interest rate risk. This goes against the principles of prudent debt portfolio construction. This is especially dangerous for investors who do not have a holistic understanding of market linked debt instruments.

No Clear Sub Limits On Exposure To Gold, Silver, REITs And InvITs

The circular allows lifecycle funds to hold upto 10% of its assets across gold ETFs, silver ETFs, Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) at all times. But there are no clear limits set for minimum exposure to each of these asset classes. This means that the fund can for instance hold the entire 10% allocation in silver ETFs while ignoring gold, REITs and InvITs.

The market for silver is quite narrow. This makes silver a lot more volatile than most other asset classes. Holding 10% in silver may therefore heighten the degree of risk inherent to the lifecycle fund. This may make the lifecycle fund unsuitable for some investors who hold it. This is all the more dangerous considering lifecycle funds are currently being positioned as a long term product aimed at goal based investing.

Imprudent Asset Allocation In Later Years

The suggested asset allocation for lifecycle funds with upto 5 years left until maturity is laid out in the graphic below.

Lifecycle funds are allowed to hold upto 50%, 35% and 20% respectively in equity with 5 years, 3 years and less 1 year left. This is grossly imprudent even with the arbitrage component. To my common sense, no form of equity exposure (regular or arbitrage) should be considered for periods less than 7 years. Variability in equity returns is very high over such periods.

Constant Active Management And Higher Costs

Managers of lifecycle funds are not mandated to follow passive strategies to manage assets at the portfolio level. They would have to constantly juggle allocations to various asset classes within the fund. Lifecycle funds are therefore hyperactive multi asset funds in essence. Needless to say, such funds would 'justifiably' command significant costs. Over a 30 year horizon these costs can significantly eat into returns. If the fund manager gets tactical calls wrong, the story would become even worse.

Single Payout At Maturity

The maturity amount in a lifecycle fund is paid out to the investor in one shot. This is true even if the investor wishes to set up a structured payout at maturity. The lumpsum payout would be accepted first. The structured payout would have to be set up subsequently. This would give rise to a significant tax liability for the investor. This would be even more true if a significant chunk of the investor's corpus were to be parked in lifecycle funds. The benefit of tax efficient deferment is lost completely.

Should Anyone Invest?

Lifecycle funds are a very new entrant in the Indian markets. A holistic understanding of lifecycle funds is yet to be developed. But a first hand understanding of lifecycle funds and investor behaviour as a whole offers the following insights :

1. No investor would park their corpus majorly or entirely in a single lifecycle fund.

2. Investing across AMCs would seemingly diversify AMC risk. But unless the funds are passively managed, it would heighten fund management risk.

3. Most investors would have other equity and debt investments outside lifecycle funds. Therefore the need to manage and rebalance the portfolio cannot be done away with entirely.

4. It is too risky for investors to expect SEBI and AMCs to take charge of their goal based investing endeavours. It is much better for them to manage and rebalance their portfolios themselves and pay associated taxes.

All of this points towards the fact that there is no compelling reason to invest in lifecycle funds. In fact investing in lifecycle funds may turn out to be riskier than DIY portfolio management. Most investors (if not all) can safely give lifecycle funds a miss.