FUND FULCRUM (contd.)
October 2017
Regulatory Rigmarole
The Securities and Exchange Board of
India’s rule asking mutual funds to re-categorise schemes based on investment
strategy will help investors get a better idea of what they are buying into. The regulator’s objective behind the move is to reduce
confusion for mutual fund investors, and deter asset management companies (AMC)
from coming out with overlapping products merely to boost their assets under
management. AMCs charge fees on the assets managed, and so larger the assets
under management, greater will be the income. Over the years, this has led to
AMCs launching a slew of schemes without much to distinguish them from the
existing offerings in the portfolio. While they would not want to say it
publicly, many AMCs are unhappy with the new rule as the cap on one scheme per
category will force them to merge many of their existing schemes. The new rule
requires investment objective, investment strategy and benchmark of each scheme
to be "modified to bring it in line with the categories of schemes
mandated therein." A change in the “type of scheme” alone would not be
considered as a change in fundamental attribute, but modification of investment
objective and investment strategy entails a change in fundamental attributes
requiring an exit option. It remains to be seen as to who bears the costs of
exit option, the scheme or the AMC. If the scheme bears the cost, this would be
additional expense to the scheme, reducing the NAV for investors to that extent.
SEBI has broadly divided mutual funds into five categories – equity funds, debt
funds, hybrid funds and solution-oriented funds and other funds. Within equity
funds, there can be 10 offerings – multi cap fund, large cap fund, large and
mid cap fund, mid cap fund, small cap fund, dividend yield fund, value fund and
contra fund, focussed fund, sectoral/thematic fund and ELSS. Fund houses have
to fit in their schemes in any one of the prescribed categories. Within the
hybrid category, too, there can be multiple offerings-- conservative, balanced
and aggressive--based on the equity component in the scheme. On the face
of it, prescribing only five scheme categories makes it simple for a lay
investor to make up his mind. At the same time, it also runs the risk of
oversimplification. There could be ambiguity about capital protection schemes. In
capital protection schemes, which have a mix of equity and debt, and are
close-ended, the emphasis is on capital protection at maturity. The strategy is
not tied to an allocation percentage, but rather flows from its asset structure
depending upon maturity duration. It remains to be seen if, in future, a
capital protection scheme would be mis-sold as a simple hybrid category
product, which it is not. The circular also requires the benchmark index of
scheme performance to be modified to fit into one of the prescribed categories.
The investment judgment of an investor on existing schemes is based on the
scheme performance vis-a-vis its existing benchmark index. If benchmark is
tweaked for existing schemes, scheme performance across the years will lose a
meaningful comparison. This requirement would be better suited to new scheme
proposals only.
AMFI has approached SEBI requesting to make MF Utilities a
market infrastructure institution for the mutual fund industry. If SEBI recognises MF Utilities as the market infrastructure
institution, all the transactions in mutual funds will go through a single
gateway i.e. MF Utilities. The platform has to provide guaranteed clearing and
settlement functions for transactions in mutual funds. This will lead to
significant improvement in the transaction efficiency, transparency, liquidity
and risk management practices in mutual funds along with added benefits like
reduced settlement and operational risk and savings on settlement costs. In
simple words, MF Utilities will become Clearing Corporate of India (CCI) of the
mutual fund industry. Currently, fund houses use different payment gateways to
settle transactions. The move would help MF Utilities get funding from fund
houses through IAP corpus.
SEBI has allowed debt fund managers to execute imperfect
hedging through interest rates futures (IRFs). This will help fund managers
reduce interest rates risk in debt portfolios. Under imperfect hedging, fund managers do not necessarily
hold a debt security in the portfolio to buy interest rate futures of that
particular security. For example, fund managers can buy interest rates futures
of a 10 year G Sec even without having exposure to 10 year G Sec in the
underlying portfolio. So far, fund managers could only hold interest rate
futures of a security if they had the security in their underlying portfolio. Fund
managers can now hold such imperfect hedged IRFs up to 20% of net assets of the
scheme. However, the fund managers will have to maintain 90% correlation
between the underlying securities and the interest rates futures. In a
circular, SEBI said, “Mutual Funds are permitted to resort to imperfect
hedging, without it being considered under the gross exposure limits, if and
only if, the correlation between the portfolio or part of the portfolio
(excluding the hedged portions, if any) and the IRF is at least 0.9 at the time
of initiation of hedge. In case of any subsequent deviation from the correlation
criteria, the same may be rebalanced within 5 working days and if not
rebalanced within the timeline, the derivative positions created for hedging
shall be considered under the gross exposure computed in terms of Para 3 of
SEBI circular dated August 18, 2010. The correlation should be calculated for a
period of last 90 days.” The move will help fund managers reduce interest rates
risk by taking a call on interest rates movements. If a fund manager believes
that interest rates will go down, he may take a long duration call by putting a
small premium. If the call goes right, the gain is unlimited; however, if it
goes wrong, the portfolio will lose only a nominal amount.
Intermediaries like Point of Presence – Service Providers
(POP-SP) and Retirement Advisers (RAs) will have to compensate their clients if
they delay KYC verification, execution and update service requests. The pension fund regulator will levy a penalty of Rs.10 or
the bank rate + 2% of the contribution amount on POP-SPs and RAs for such delays
in service requests with effect from October 1, 2017. Through a circular issued
recently, PFRDA said, “In case of any delay or violation in the service
standards in respect of prospective/ existing NPS subscriber, the POP including
POP-SP or POP–SE as the case may be, shall be liable to compensate the loss to
the subscriber.” The penalty fee will be credited to the subscribers’ permanent
retirement account number (PRAN).
AMFI has directed fund houses to ensure Aadhaar linking of
existing folios before December 31, 2017 to avoid account freezing. In line
with the Ministry of Finance rules on prevention of money laundering, Aadhaar
has been made mandatory for mutual fund investments with effect from January 1,
2018. In an email communication, AMFI has
said that no new folios can be opened from January 1, 2018 if Aadhaar is not
provided at the time of making an investment in mutual funds. AMFI has also
directed fund houses to ensure linking of Aadhaar details with existing folios
before December 31, 2017. AMFI has asked fund houses to freeze non-Aadhaar
compliant accounts with effect from January 2018. This means, non-Aadhaar
compliant investors cannot execute fresh mutual fund transactions. Though fund
houses can allow investors to invest in mutual funds without furnishing Aadhaar
details at their discretion, they will have to update such details before
December 31, 2017. Investors can link their Aadhaar number with mutual fund
folios through R&T agents such as CAMS and Karvy. The RTAs have enabled
online submission of Aadhaar and PAN details by investors on their websites for
collection and authentication of Aadhaar number. You may provide such details
at any of the RTA's websites. Physical forms will soon be available at all the
investor service centres (ISCs) of the AMCs and RTAs. AMCs will send emails to
distributors and investors with a weblink to update Aadhaar. Investors can send
SMS from registered mobile number to link Aadhaar.
India's capital markets regulator is
likely to allow mutual funds to trade in commodity derivatives and a decision
is expected within six months. Such
a move would help deepen the market and provide hedging opportunities to large
companies that trade overseas due to limited liquidity at local exchanges.
Portfolio management services and foreign trading houses that export or import
from India could also be allowed to participate in commodity futures. The
participation (of mutual funds) is in an advanced stage of examination. Asia's
third-biggest economy allowed commodity futures trading in 2003, but has so far
kept out foreign investors, banks and mutual funds, among others. In June, SEBI
for the first time allowed institutional investors to trade in commodity
derivatives as it said hedge  funds registered as category III
Alternative Investment Funds (AIFs) can invest in the segment.
Although India stands alongside US in terms of
mutual fund disclosures, it earns a top grade for disclosing the fund manager’s
remuneration, states Morningstar’s recent report titled, ‘Global Fund Investor
Experience Report 2017’. The report grades the experience of mutual fund
investors in 25 countries across North America, Europe, Asia and Africa. Thanks
to SEBI’s regulatory norms, India scores over US in terms of better mutual fund
disclosure policies. The report says, “Disclosure in India earns a Top grade.
Transparency of portfolio holdings remains the best of any market, with monthly
disclosure required and those portfolios typically released after 10 days. It
is now mandatory for asset managers to disclose fund manager compensation
levels as well as manager investments in their funds. Regulations have also
been introduced requiring the disclosure of commissions earned by distributors.
Point-of-sale documents include details around fund risks, but our analysts
observe that the descriptions of investment strategies are often insufficient.”
In terms of disclosures, we are ahead of many major markets. However, we can
level up our disclosure standards by making a few more changes. For instance,
AMFI currently publishes Quarterly AUM of fund houses data, it could instead
publish it share class level AUM data monthly for more transparency. Also, the
recent categorization of the mutual fund schemes will now make investment
mandates more clear for investors.” While the US is the most investor friendly
market, India has retained an overall grade of ‘Average’ in terms of investor
friendly market, said the report. The report further highlights that investment
advice has improved over time. It attributes the improvement to a range of
initiatives starting from Investment Advisory Regulations in 2013 and
more-recent moves to put caps on upfront commissions paid by product providers.
The report also states that India’s ‘Fee and Expenses’ grade is below average.
“It reflects some of the highest expense ratios for equity funds in the study
and the reliance of ongoing trailing commissions to pay for advice”, the report
said.
