FUND FULCRUM - DECEMBER 2008

FUND FULCRUM (contd.)

(December 2008)

Ever since mutual funds caught the fancy of the Indian investors, they used to be a means of gain for investors in both good and bad times. But 2008 was different.

A sprawling global crisis of confidence emerged during 2008, dragging financial markets into unprecedented levels of volatility. The year began with a U.S. housing market correction already in progress. Falling housing prices, rising mortgage default and foreclosure rates, and financial-sector write-downs tied to mortgage-backed securities were all elements of this correction that gained momentum throughout 2008. The presence of deteriorating mortgage assets on the books of commercial and investment banks plus instability fueled by credit default swaps led to takeovers, bankruptcies and government intervention among financial firms.

Indian mutual funds became poorer by about Rs 1,50,000 crore, or about one-third of their total size. So did the investor’s kitty…

Piquant Parade

At a time when the mutual fund industry is reeling under the pressure of recessionary tendencies, Kolkata-based Peerless General Finance & Investment Company Limited, the first financial services company in Eastern India, has got preliminary in-principle approval from SEBI to set up an asset management company.

Cost cutting comes automatically in times of falling AUMs. Fund houses have begun negotiating with brokers, custodians and transfer agents to lower service charges. Several brokers, on their part, have reduced dealing charges (for institutions) from 0.25% to as low as 0.10% of the total transaction size.

On the other hand, in a bid to bolster their sagging AUMs, mutual fund houses are pampering distribution agents with unique incentives to boost sales. Fund houses are handing out upfront commission and monetary remuneration to increase fund sales. In addition to the 2.25% as entry load and 0.5% trail commission, distributors are being offered 0.5% extra commission for every fund sold. Instead of annual commission, which was the case until some time ago, fund houses are now offering an upfront commission of 1% for selling gilt and income funds.

Regulatory Rigmarole

SEBI has made the listing of all close-ended mutual fund schemes (except equity-linked schemes) that are launched on or after December 12 mandatory. Since the trading of units takes place only on the exchange, NAVs will not be impacted. Investors who stay on in the scheme are protected to a great extent and the fund manager is also not forced to sell securities before maturity at a huge discount, as is the case now when large investors in close ended schemes pull out. However, there will be a listing cost involved in the form of listing fees which may be recovered from the investors in the scheme. These will be part of the expenses for the fund, but will be lower than the exit load. For close ended schemes, the underlying assets will not have a maturity beyond the date on which the scheme expires. The new norms have come in wake of a liquidity crisis faced by the mutual fund industry when investors heavily redeemed from fixed income funds fearing their credit quality after rumors that funds had invested in commercial papers of real estate companies and NBFCs who were unable to pay them back.

New tougher norms are likely to be created for Fixed Maturity Plans (FMPs) if SEBI accepts the recommendations of AMFI. FMP schemes, which have a maturity between one and three months, must have a minimum 30% allocation to cash, collateralised borrowing and lending obligations (CBLO), bank fixed deposits, treasury bills and others - all safe and liquid instruments. In addition, AMFI has recommended that 30% of the investment can be made in bank fixed deposits against a present norm of 15% in bank FDs and 20% with board approval. Moreover, the maturity-mismatch has to be contained at 10% of the tenure of the instrument or one month, whichever is lower. AMFI has also recommended that all fixed-rate instruments above three months (instead of six months at present) should be marked to market. For debt funds, the valuation of the underlying papers is currently based on CRISIL`s valuation matrix. AMFI has proposed outsourcing these valuations to an independent third party. The Securities and Exchange Board of India in its board meeting today decided to fix the structural flaw in fixed maturity plans. It was decided that no early exit will be allowed in any scheme of mutual fund in the nature of a closed-end scheme. The schemes which have been approved earlier but not yet launched will also have to be amended accordingly.

The issue of sectoral caps on mutual fund investments has come up for discussion. Company-wise and industry-wise caps are being discussed by the Association of Mutual Funds in India. Some funds have over 90 per cent exposure to the banking and financial services sector. With real estate stocks facing the brunt of the meltdown, SEBI is likely to take steps to discourage mutual funds’ high exposure to the real estate sector.

The Securities and Exchange Board of India is discussing the issue of increasing the borrowing limit of a mutual fund from the existing 20 per cent to 40 per cent of the net assets of a scheme for a six-month period. This is to enable them to meet temporary liquidity needs like repurchase, redemptions or payment of interest or dividend. In order to meet sudden redemption pressures, liquid funds may be disallowed from holding securities with a maturity exceeding 90 days.

SEBI is set to discontinue the differential loads on high-value investments, in an attempt to provide a level-playing field to mutual fund investors. The move will balance the load for retail investors, who often end up subsidising their institutional counterparts.

The mutual fund advisory committee to SEBI, headed by S A Dave, has recommended that investors should pay the commission to distributors directly. As per the current norm, the commission is deducted from the total investments in mutual funds. As per the committee, since distributors provide services to investors, the commission should come from the investors themselves. Further the committee feels commission can also be negotiated, depending on the standard of the service.

The Dave committee has recommended that the practice of mutual funds declaring indicative return and indicative portfolio be stopped. However, the market regulator may make it mandatory for funds to disclose their entire portfolios once a month on their websites. Currently, most fund houses do not disclose the extent of exposure they have to pass through certificates (PTCs) and securitised paper.

The committee has discussed hiking the minimum networth requirement for mutual funds from Rs 10 crore to Rs 50 crore and networth of the sponsor to be five times the networth of the fund. However, this may take some time because the advisory committee that includes representations from investors’ associations is divided on this issue. A section of the industry feels that mutual fund is the domain of the fund manager. Raising the networth requirement may hamper individual fund managers from entering the asset management space.The other view is that a strong sponsor can infuse additional capital and provide liquidity support, if required.

Government has allowed navaratnas and miniratnas to invest upto 30% of their surplus in equity through public sector mutual fund schemes. The scheme to allow navratnas and mini-ratnas in this regard expired on August 1 this year, a year after it was notified.

Indian banks, insurance companies and mutual funds will soon have the opportunity to manage pension funds. The Pension Fund Regulatory and Development Authority (PFRDA) sought applications from entities wishing to float pension funds to manage retirement assets of all Indian citizens, other than government employees already covered under the existing pension scheme. Detailed criteria set out by PFRDA in its primary information memorandum (PIM) entitle government institutions, banks, insurance companies and mutual funds to sponsor a pension fund. One important criterion is that the sponsor must have at least five years of experience in running debt and equity funds and should have managed average monthly assets of Rs 8,000 crore for 12 months ended November 30, 2008.

SEBI has asked fund houses to aggressively market debt schemes to retail investors and also to focus on rural markets. According to data compiled by SEBI out of the 44.4 million investors, 87% are from urban centers. The corporate sector accounted for 56.55% of the mutual fund industry's AUM in debt schemes. The share of retail investors was only 6%, with the remaining accounted for by HNIs and other institutional investors.

The weak close to the year 2008 could provide an excellent ground for rebuilding as this is the appropriate time for investors to buy for the long term. Probably on account of this, the industry saw new fund houses entering or planning to enter the space this year. The ensuing year, 2009, could see much more consolidation on the back of declining assets under management and the rising cost of services, when a number of small fund houses could be sold to their bigger rivals. The much-awaited turnaround could also materialize in 2009…..but let us not resort to crystal gazing…..let events unfold at their own pace…..for informed and intelligent investors the opportunities beckon right now!!!