FUND FULCRUM (contd.)

December 2013

 

The Indian mutual fund sector’s slide started in 2009, after the Securities and Exchange Board of India banned entry load, an upfront fee funds charged investors to pay distributors. Since then, many distributors have been indifferent to selling mutual funds. The continued bear market added to the woes. Smaller fund houses were hit harder because these could not compete with larger peers’ deep pockets for pushing products. In the past four years, the share of the top 10 funds in the sector’s total assets rose to almost 80%. Currently, there are a little over 40 entities in the mutual fund sector. Hardly a third of them are profitable.

 

Piquant Parade

 

Morgan Stanley became the second largest global giant to exit India's crowded and barely profitable mutual fund industry when it agreed to sell its business to HDFC, the country's biggest mutual fund manager. HDFC Mutual Fund, with assets of Rs 1.03 lakh crore, agreed to buy all eight schemes of Morgan Stanley with combined assets of Rs 3,290 crore. The purchase is expected to help the fund widen the gap with Reliance, the second biggest mutual fund house and consolidate its position at the top of the industry. Reliance has assets worth Rs 93,249 crore. Morgan was the first global fund to launch a mutual fund in India in 1994 after liberalisation but its performance in the country has been rather lacklustre. Its asset size is small by international and Indian standards and like Fidelity it has been unable to keep pace with the growth of Indian mutual funds such as HDFC Mutual Fund, Reliance Mutual Fund, ICICI Prudential, UTI Mutual Fund, and Birla Sunlife which between them control over 50% of the industry's assets. The fund posted losses in both 2011 and 2012. Morgan becomes the second big global investor to exit the local market after Fidelity which sold its business to L&T in March 2012. Daiwa sold its assets to SBI Mutual Fund for an undisclosed amount this year and this was preceded by Invesco's purchase of a 49% stake in Religare for Rs 460 crore and Nomura's acquisition of 35% in LIC Mutual Fund for Rs 308 crore.

Regulatory Rigmarole

Small fund houses are up in arms against the SEBI Mutual Fund Advisory Committee’s  recent proposal to raise minimum net worth of fund houses having AUM of less than Rs 1000 crore to Rs 25 crore within three years. Presently, fund houses have to maintain a minimum net worth of Rs. 10 crore. The 16-member committee is headed by Janki Ballabh, former Chairman of the board of trustees of UTI Mutual Fund. Only 1% of the AUM is from the bottom 10 AMCs. This percentage has not changed substantially in the last five years and it is indicative of the presence of non-serious players in the industry.

Research analysts will soon have to obtain a certificate from the capital market regulator to continue giving opinions and recommendations on listed companies. SEBI issued draft Research Analysts Regulations, 2013, which mandated all research analysts to obtain a certificate of registration, have right educational qualification, and also a minimum net worth. SEBI has proposed research analysts, which are corporate bodies, will have to maintain net worth of at least Rs 0.5 crore, while individual or partnership firms will have to have net tangible assets of Rs 500,000. The certificate will be valid for five years. Research firms incorporated outside India will have to set up a subsidiary in India and register it with SEBI. SEBI has exempted investment advisers, asset management companies, proxy advisory service providers, and fund managers. However, if these entities provide their views through the public media, they will have to follow the processes regarding conflict avoidance and disclosures. Analysts or a brokerage will not deal in shares of companies a month before and five days after publishing of a research report. Analysts will be barred from publishing or recommending a security if they are traded in the previous 30 days. The compensation or bonuses of an analyst should not be tied to any specific investment banking or brokerage transactions. The regulations also bar an analyst or a brokerage from issuing research reports or making public appearances on companies where they act as investment bankers in IPOs or FPOs. The proposed regulations also bar distribution of research reports to selective clients in advance. In addition, analysts distributing third-party reports can do so only after ensuring their accuracy.

Dealing room activities of brokers, fund managers, and other institutional investors have come under regulatory scanner for possible manipulations through use of web-based social networking apps and messaging platforms. While use of personal mobile phones are already prohibited inside dealing rooms -- where trades are executed on behalf of clients -- some brokers and fund managers have been found to be active on social networking and other web-based groups and messaging platforms while placing orders. This has brought to the fore significant risks of insider trading, front running and other manipulative activities with regard to key client trade information being shared with outside investors or even among the dealers possibly working as a cartel. Brokers and fund managers are not allowed to use their personal mobile phones inside dealing rooms to receive orders from clients, while fund houses and brokerage firms are required to store records for all client calls for future inspections by SEBI. SEBI is considering further tightening of norms with regard to dealing room communications, given the fast emergence of social networking and other web-based messaging platforms. Those likely to be affected include entities dealing in stocks, derivatives and currency trading, among others. In a global probe into suspected rigging of forex rates, including those involving rupee as well, foreign regulators already suspect use of intra-bank and web-based messaging platforms among the currency traders. Subsequently, many large global banks have already started clamping down on use of such platforms inside their dealing rooms and similar action can be expected with regard to Indian markets as well.

The market watchdog is already mulling over steps it can take to check risks being posed by use of new-age smartphone messaging services like BlackBerry Messenger (BBM) and WhatsApp by manipulators to spread sensitive information about their target stocks. To strengthen its surveillance on stock market transactions, SEBI has already got software tools in place along with IT experts to analyse discussions on social networking sites like Twitter and Facebook. However, applications like WhatsApp and BBM have proven trickier, given the multi-level difficulties faced in tracking the source and spread of market-sensitive information through these mass-messaging platforms. While these applications use the internet servers of smart phones, the transmission of messages through these platforms happen in a highly encoded manner and it is very difficult for a third party to decode them.

SEBI has released consultative guidelines for the operation of REITs in India, five years after it first introduced the initial guidelines. REITs are investment vehicles that invest in return-generating real estate. This investment may either be in the form of properties, mortgages or mortgage-backed securities. The trust collects money from retail or institutional investors in return for shares in the property and its managers then deploy the funds into real estate (usually commercial) projects. The income—mainly rent or lease—is then distributed as dividend among investors. In this way, REITs are similar to mutual funds. But there are some important differences, the prime one being that REITs directly buy property instead of investing in property stock. REITs are focused on one sector and invest in a limited set of assets therein. SEBI’s list of regulations is more stringent. It states that 90% of the total investment corpus must be put into completed revenue-generating real estate within India. REITs cannot invest in vacant or agricultural land or mortgages (except mortgage-backed securities). These limitations are clearly aimed at improving the risk and return profile of REITs. In addition, three-fourths of the revenues shall necessarily be from rental, leasing and letting of real estate assets, and 90% of the after-tax income must be distributed to investors. To weed out fly-by-night operators, the regulator has set a minimum corpus size of Rs.1,000 crore for REITs. Further, when a REIT gets listed, the initial offer size must be at least Rs.250 crore, of which 25% must be publicly floated. SEBI has also proposed that the minimum subscription size be set at Rs.2 lakh and that high networth individuals and institutions be approached as initial investors until the market develops. All in all, the draft regulations are geared towards protecting the investor, while simultaneously opening up the liquidity tap and ensuring total transparency of operation. The regulator seems to have performed a laudatory balancing act. However, this is not to say that REITs do not have their own risks. While they promise investors stable returns, they do have some aspects comparable to equity markets. For instance, a downturn in real estate can impact investors’ ability to sell off their shares (since real estate is an illiquid asset and selling a property can take time). Moreover, there are some taxation issues. In the current form, experts feel the tax burden could exceed 40%. However, it is believed that plans are afoot to make REITs a pass-through investment, which will make them taxable only at a single point, i.e., in the investor’s hands.

Distributors have requested AMFI to consider relaxing the unique identification (EUIN) rules. They want EUIN remediation period to remain 30 days as is the rule currently. Distributors were required to provide valid EUIN within 30 day from the end of the month in which the transaction took place. The commission withheld was released by fund houses if distributors remediate it within this period. From January 01, 2014, this remediation period will be seven days from the end of the month in which the transaction takes place. For instance, all transactions submitted prior to January 01, 2014 have to be remediated from February 07, 2014 and within seven days from subsequent months. Thus, distributors risk losing their commission if there are unable to provide EUIN within the stipulated remediation period. Quoting EUIN in application forms became mandatory from June 01, 2013 for purchases, switch, registration of SIP / STP / DTP / trigger. SEBI introduced EUIN to address the issue of mis-selling. Distributors have to get EUIN for all employees who advice clients. This helps track the employee/relationship manager if in case of mis-selling. If there is no interaction between the employee of the distributor with respect to a particular transaction, distributors have to get a declaration signed by the investor. If the distributors fail to furnish this declaration to the AMC within the remediation period, their commissions are forfeited permanently.

SEBI has modified account opening forms (AOF) by doing away with annual income and occupation details of clients to be captured in KYC forms. It has now been decided in consultation with various market participants to shift certain information (annual income, occupation) in Section C of Part I to Part II of the account opening form AOF (for both individuals and non-individuals). Part I contains the basic KYC details of the investor used by all SEBI registered intermediaries and Part II captures additional information specific to the area of activity of the intermediary. Information contained in revised Part I of AOF shall only be required to be captured in the systems of KRAs. SEBI has given a timeframe of six months to make modifications to KYC forms. The modifications would assist in avoiding repeated modifications in the KRA system as information provided by the clients in Section C changes over a period of time and will facilitate in making the KYC uniform for the entire financial sector. Distributors say that the KYC norms are stringent for non-individuals as they have to furnish their financial details every year.  Companies and partnership firms are supposed to submit copy of the balance sheets for the last two financial years. This is required to be submitted every year which is a tedious process. Income and net worth data will still be required to be captured in order to comply with Prevention of Money Laundering Act (PMLA). Client’s income can change every year and this was not getting updated in the systems of KRAs since it is not feasible to perform KYC multiple times.

AUM data for the initial three quarters of 2013 suggests that the year has been sluggish for the mutual fund industry. In fact, notably, during the year, no new licenses were issued, there were no M&A activities and no fresh foreign investment flowed into the sector. SEBI had, in the past, taken steps to re-energise the mutual fund industry with continued focus on investor protection. These steps have contributed a sense of stability to the mutual fund industry, which has been operating in a challenging environment. Going forward, SEBI could adopt a stricter approach towards 'non-serious' asset managers. An advisory committee formed to review the net worth requirement for AMCs has suggested an upward revision in the minimum net-worth required for an AMC. Debt schemes continue to be the flavour of the season. The first Infrastructure Debt Mutual Fund scheme (mutual fund-IDF) was launched in the year 2013. Further, while mutual fund AMCs have shown interest in tapping the pension products market, in the absence of adequate tax incentives, this is yet to take-off. From an asset management industry perspective, the proposal to launch REITs could provide an alternative investment avenue to investors. While the Government has pro-actively amended the law to resolve taxation issues for mutual fund industry on investment in securitisation trusts, the industry remains circumspect and the amendments have failed to attract investments by mutual funds in securitisation trusts. The industry continues to litigate past tax issues on securitisation trusts. In a sense, the performance of the mutual fund industry has, to an extent, mirrored the performance of the Indian economy, the stock markets, and the FII investment (or divestment) story. With elections on the anvil, an element of 'uncertainty' could prevail for the next quarter or so. Moving on, the industry looks forward to quick and clear directions on safe harbour for management of offshore funds from India and other similar measures whereby tax can be a facilitator for growth. Nearly fifty years old, the Indian Mutual Fund industry is fraught with a number of challenges. The penetration of mutual funds in India (as measured by the AUM/GDP ratio) remains low at 4.7% as compared to 77.0% in the US, 41.1% in Europe and 33.6% in the UK. Greatly under-penetrated, the industry comprising over 40 mutual fund companies today collectively manages 2.5% of Indian household savings. The right kind of awareness among investors about mutual funds, the diversity and benefits of its offerings remains a challenge. Being an advisory product which is largely distribution driven, stagnation in growth of distributor base also acts as a limiting factor.