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.