FUND FULCRUM (contd.)

December 2019

Mutual funds have added over Rs 4 lakh crore to their asset base in 2019 and the industry expects the growth trajectory to continue in 2020 on the back of strong inflows in debt schemes and measures taken by regulator SEBI for boosting investors' confidence. It was the strong inflows into debt-oriented schemes that saved 2019 from being a "dark-dull year of investing" as inflows into equity funds dropped this year due to a volatile market. Going ahead, the industry should witness growth in the range of 17-18 per cent in 2020 and equity funds should see robust inflows as expectations are high about improved equity markets and a revival in economic growth. The asset under management (AUM) of the industry rose by 18 per cent (Rs 4.2 lakh crore) to an all time high of Rs 27 lakh crore in 2019 by November-end itself, up from Rs 22.86 lakh crore at the end of December 2018, as per the latest data available with the Association of Mutual Funds in India (AMFI). The final December-end figure might be slightly lower than the November-end level, as liquid funds could see some dip due to the quarter-end phenomenon. The investor count is estimated to have grown by over 62 lakh during 2019, to 8.65 crore this year. In 2018, investors' folio grew by more than 1.3 crore. The 18 per cent AUM growth seen by the 44-member mutual fund industry in 2019 is significantly higher than 7.5 per cent witnessed in 2018. However, the growth was much higher at 32 per cent in 2017, when the asset base expanded by over Rs 5.4 lakh. The growth in AUM can be attributed to three factors -- first, SEBI, as a regulator, consistently created rules and regulations that boosted investors' confidence in the industry, then to distributors and thirdly to the mutual funds for managing risk-return balance well. The year 2019 marks the seventh consecutive yearly rise in the industry AUM after a drop for two preceding years. The AUM of the industry has grown from Rs 8.22 lakh crore in November 2009 to Rs 27 lakh crore in November 2019, indicating an over three-fold jump in 10 years. The growing SIP book has contributed to the positive sales and SIPs will continue to be one of the most important parameters for the growth of net sales for the industry as a whole. The industry is poised for a significant growth in 2020 as sentiment improves with economic growth reviving and the credit crisis shows signs of being resolved.

Regulatory Rigmarole

SEBI has recently released norms for debt ETFs and index funds that restricted any single issuer from having more than 15% weight in the index that they replicate. The circular has come ahead of the proposed issue of the first debt ETF catering to the borrowing needs of public sector enterprises. Edelweiss AMC will manage this debt ETF.  Here are some other notable norms: The constituents of the index need to be aggregated at the issuer level. The index should have at least 8 issuers. The rating of the constituents of the index needs to be investment grade. The constituents of the index have a defined credit rating and maturity as specified in the index methodology. If the rating of an issuance falls below the investment grade or rating mandated in the index methodology, rebalancing by debt ETFs and index funds needs to be done within 5 working days. On replication of the index by debt ETFs and index funds: Debt ETFs and index funds will replicate the benchmark index completely. In case this replication is not feasible due to non-availability of issuances of the issuer forming part of the index, the debt ETFs and index funds will be allowed to invest in other issuances issued by the same issuer having deviation of (+/-) 10% from the weighted average duration of issuances forming part of the index, subject to single issuer limit. Further, at aggregate portfolio level, the duration of debt ETF and index fund need not deviate (+/-) 5% from the duration of the index. Even after this, if the replication is not feasible, the Debt ETFs/Index Funds can invest in issuances of other issuers within the index having duration, yield and credit rating in line with that of the non-available issuances of the issuers forming part of the index, subject to single issuer limits. The duration of debt ETF and index funds shall not deviate (+/-) 5% from the duration of the index. The rationale for any deviation needs to be recorded. SEBI said that these norms will not be applicable to debt ETFs and index funds, which only track debt indices having constituents as government securities, treasury bills and tri-party repo.

SEBI relaxes norms related to group level exposure in debt and liquid funds. In a mild relief to fund houses with respect to their debt holding in their group companies, SEBI has given an option to fund houses to hold debt papers issued by the their group companies until maturity. However, this relaxation is only applicable to debt instruments, which was in the portfolio of debt funds and liquid funds before October 1, 2019. In a circular issued, SEBI said, “The investments of mutual fund schemes in debt and money market instruments of group companies of both the sponsor and the AMC of the mutual fund in excess of the limits specified therein, made on or before October 1, 2019 may be grandfathered till maturity date of such instruments. The maturity date of such instruments shall be as applicable on October 1, 2019.” Earlier in October, SEBI had put a restriction on such exposures to 10% of the net assets of the scheme. Such investment limit can touch 15% of the net assets of the scheme with the prior approval of the board of trustees. SEBI has asked fund houses and AMFI to publish list of such holdings on their respective websites from January 1, 2020.

In a gazette notification issued recently, the government has reintroduced stamp duty tax on financial securities transaction. With this, investment in direct stocks, mutual funds, ULIPs and NPS will become a bit more expensive for investors from January 9, 2020. Since mutual funds deal with shares, every time a fund manager executes transaction, the fund has to pay stamp duty along with securities transaction tax. Mutual fund industry executes transaction of Rs.5 lakh crore each month in equity and debt markets. Clearly, the impact of stamp duty would be large. The government has clarified that there will be a common rate for all states. The government also said that stock exchanges will have to track origin of investors to distribute stamp duty among states. Government has announced the new stamp duty rates in which it has imposed stamp duty of 0.0001% on transfer and re-issue of equity and equity related instruments. For debt instruments, the government will levy stamp duty tax of 0.015% on delivery transactions and 0.003% on intraday and option transactions. In case of equity IPOs and fresh issuance of debt papers, the government has imposed stamp duty tax of 0.005%. The stamp duty tax on futures both equity & commodity and currency & interest rate derivatives would be 0.002% and 0.0001, respectively. There will be no stamp duty tax on transaction of government securities. Finally, the government would levy stamp duty of 0.00001% on transaction of repo on corporate bonds. These rates will be common for all investors irrespective of their physical location. Since mutual funds deal with shares, every time a fund manager executes transaction, the fund has to pay stamp duty along with securities transaction tax. Clearly, the impact would be more on funds with high turnover ratio.

SEBI releases new norms for AMCs providing management and advisory services to FPIs. AMCs can provide management and advisory services only to specified categories of FPIs. SEBI has now specified the categories of FPIs that AMCs can provide management and advisory services to:

a. The FPIs can be government and government-related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies. Here the government-related investors also include entities in which the government owns (directly or indirectly) at least 75% stake

b. The FPIs can also be appropriately regulated entities such as pension funds, insurance or reinsurance entities, banks and mutual funds

c. Appropriately regulated FPIs wherein the above-mentioned entities hold more than 50% of shares or units

The new norms have come into force with immediate effect for all AMCs. However, SEBI has given a relaxation period to AMCs that already have an agreement to provide management and advisory services to FPIs that do not fall in any of the above categories. Such AMCs can continue to provide the services until December 16, 2020 or as mentioned in the agreement, whichever is earlier.

SEBI has asked fund houses not to allow transactions i.e. accepting fresh money or honouring redemption after minor turns major and does not submit KYC details. Currently, the industry does not have a uniform policy to deal with minor to major accounts. Hence, a few AMCs allow transactions or accept fresh money even after the minor turns major. SEBI has further asked AMCs to put a mechanism to discontinue SIPs, STPs and SWPs on such accounts. Parents or guardians can invest in mutual funds on behalf of their children through a minor account. Since children do not have income and mandatory documents like PAN, Aadhaar and bank account, AMFI rules mandate parents to invest in mutual fund through their KYC details. Now, when a minor becomes a major on attaining 18 years of age, she has to complete the KYC process in her own capacity and notify each of the concerned mutual funds by filling up a prescribed ‘minor attaining majority form’ in order to be able to transact further in her folios. Typically, in such a scenario, most ‘minor turns major’ investors take a little while to complete their KYC.

SEBI has simplified the process of transmission of units in mutual funds due to absence of nominations or death of unitholders. Among its key measures include bringing uniformity across fund houses in dealing with transfer of assets due to demise of unitholders and spreading awareness about importance of nomination in mutual funds through IAPs. Here are some of the other key changes:

•             Introduction of image based processing wherever the claimant is a nominee or a joint account holder in the investor folio

•             AMCs to set up a dedicated central help desk and a webpage carrying relevant instructions to provide assistance on the transmission process

•             AMCs to introduce a common transmission request form and NOC form

•             A uniform process across fund houses to deal with unclaimed funds to be transferred to the claimant including the unclaimed dividends

•             AMCs cannot accept requests for redemption from a claimant until the units are transferred in his favour

•             Claimant has to pay stamp duty tax

SEBI has made it mandatory for all MFs and AIFs to follow a ‘Stewardship Code’ in relation to their investment in listed equities. Institutional investors such as MFs and AIFs should enhance monitoring and engagement with their investee companies. For instance, institutional investors should engage with investee companies on operational performance, financial performance, strategy, corporate governance, remuneration, ESG guidelines and so on. The regulator feels such increased engagement would improve corporate governance and benefit clients of institutional investors. SEBI defines such activities as ‘Stewardship Responsibilities’ of the institutional investors. The ‘Stewardship code’ is a principles-based framework to fulfil these responsibilities. The code mandated by SEBI today is based on six principles and would come into effect from April 1, 2020. Principle 1 - Institutional Investors should formulate a comprehensive policy on the discharge of their stewardship responsibilities, publicly disclose it, review and update it periodically. In case any of the activities are outsourced, the policy should provide for the mechanism to ensure that in such cases, stewardship responsibilities are exercised diligently. Principle 2 - Institutional investors should have a clear policy on how they manage conflicts of interest and publicly disclose it. The policy should ensure that the interest of the clients come before the interest of the entity. The policy should also address how matters are handled when the interests of clients or beneficiaries diverge from each other. Principle 3 - Institutional investors should monitor their investee companies. Among other things, they should monitor company strategy and performance, quality of company management, board, leadership etc. SEBI stipulates that the investors should identify the levels of monitoring for different investee companies, areas for monitoring, mechanism for monitoring etc. The investors may also specifically identify situations where they do not wish to be actively involved with the investee companies e.g. in case of small investments. Principle 4 - Institutional investors should have a clear policy on intervention in their investee companies. Institutional investors should also have a clear policy for collaboration with other institutional investors to preserve the interests of the ultimate investors. Principle 5 - Institutional investors should have a clear policy on voting and disclosure of voting activity. This requires a comprehensive voting policy to be framed by the institutional investors. It includes details of mechanisms of voting, circumstances in which voting should be (for/against/abstain), disclosure of voting, etc. The voting policy and voting decisions including rationale for decision should also be disclosed to public. Principle 6 – Institutional investors should report to their clients periodically on how they have fulfilled their stewardship responsibilities. Different principles can be disclosed with different periodicities. For example, voting may be disclosed on quarterly basis while implementation of conflict of interest policy may be disclosed on an annual basis.

SEBI has come out with code of conduct for investment advisors in which it has asked registered investment advisors (RIAs) not to accept advisory fee in cash. Instead, the market regulator has directed RIAs to accept fees through cheque, demand draft, NEFT, RTGS, IMPS and UPI. In a circular issued, SEBI said, “It is observed that investment advisers are receiving advisory fee in the form of cash deposit in their bank accounts or through payment gateways which does not provide proper audit trail of fees received from the clients.” The other things the code of conduct stipulates are RIAs will have to strictly ensure risk profiling and product suitability. RIAs can no longer give advice on free trial basis i.e. advising without considering risk profile of client free on cost (happens largely on phone calls). RIAs should obtain written consent of clients on completed risk profile through registered email or physical document and highlight their mobile number on homepage of their website. Such a phone number has to be prominently displayed (without scrolling) using font size of 12. To highlight details on status on complaints on website and mobile app prominently. All these guidelines will come into effect from January 01, 2020. Most of the regulations will only affect advisory firms who are primarily into stock advisory and trading business. In fact, many of these advisors do not deal with mutual funds at all. Most of these companies are based out of Indore and Bhopal.

From April 1, 2019, fund houses have rationalised TER based on asset size of the scheme. While the market regulator has capped TER at 2.25% in equity funds and 2% in all other   funds, SEBI has followed economies of scale to reduce TER systematically. The entire exercise has lowered margins of distributors as most fund houses have shared TER cut with their partners. An analysis of the commission structure shows that most fund houses have reduced trail commission by 15-20 bps largely due to reduction in overall TER. More research houses such as Citi India and CLSA said that the impact would be more acute on distributors. In fact, they have estimated that the reduction in earnings of distributors is 15 to 20 bps. However, AMCs reduced trail brokerage on assets of distributors twice due to reduction in TER in lieu of exit load and the TER cut. Since the trail commission on old assets was already close to 50 bps, the impact of these consecutive TER cuts is more acute on such assets. While IFAs claim that they get close to 80 bps trail commission on assets mobilized after 2015, they get between 15 and 30 bps on assets built before 2015. Post TER cut, the financial distribution has seen consolidation in business to reduce costs and grow business. Among some key benefits of such a merger are: reduction of costs by sharing various expenses such as execution platform, software, back-end operations, customer communication, marketing expenses and so on, learning and mentoring from each other and better commission structure compared to individual IFA. TER of all regular plans has come down drastically. In fact, in a few instances, the cost of the regular plan of a fund has come down to 0.30% largely because of reduced GST component. This is largely because of doing away with fungibility i.e. fund houses cannot spill over the cost from their AMC book. Now, fund houses have to disclose break up of their expenses such as management fee and other expenses separately. Earlier, expenses were fungible i.e. fund houses were allowed to disclose the base TER without giving segregation of various expenses. Now, with this going away, fund houses can charge GST component in management fees only instead of the entire cost. For instance, if a scheme had an expense ratio of 2.50%, the scheme used to charge GST on 2% (excluding distribution expenses of 0.5%) irrespective of actual management fees. However, now fund houses can charge GST only on fund management fees i.e. if management fee is 1.5% then the GST will be charged on 1.5% instead of 2% earlier.

The regulator is tending to see every facet of the asset management industry through the 'Mutual Fund' lens. With over 300 players, a savvy investor segment and a current robust regulatory framework, this industry is competitive enough to grow on its own steam – SEBI's proposed regulations will surely keep nudging it in the right direction. The markets will tend to surprise in the short run, and hence it is very difficult to have a '2020 vision', but the long-term trend of the industry looks very promising indeed!