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Mutual Funds - Three regulation changes that make mutual funds safer
14-Oct-2020

The closer you examine the financial sector, the more you get to believe that parts of the industry believe that if there is a way to do something wrong, why do it the right way? Not for all the firms in the market, but a few aggressive ones. And these cause regulators to go on tightening rules that finally hurt the market as the compliance costs and complexity keeps growing. The first 10 days of October saw the market regulator in an overdrive to push through long-pending reform that make the mutual fund product safe for retail investors. The speed could have some connection with the date of whole-time member Madhabi Puri Buch’s term completion coming closer, though she recently got a one-year extension. Buch has been a prime driver of change in the last couple of years and has also energized the mutual fund department into a data-crunching, evidence-building and change-enforcing machine. These are all good things for investors, of course. Three changes and what they mean for you.

One, your dividend option will now be called by its correct name and hopefully will stop the mis-selling associated with this option. A dividend is the distributed profit per share. In mutual funds, there have been three options in front of an investor—growth, dividend and dividend reinvestment. The two dividend options were a way to look after the needs of investors who wanted to book profits from their money and receive an income. But the dividends declared contains a part of the capital as well. Some fund houses mis-sold the dividend option, specially in smaller towns, making it seem like a bank FD with a regular monthly “dividend". To rectify this mis-communication, Sebi changed the rules once again. You can read the circular here.

The idea to rename the dividend, dividend reinvestment and transfer options and call it “income distribution cum capital withdrawal plan" is aimed at labelling the option better. What you should do? Go for a growth option and use a systematic withdrawal plan to realize regular income if you need it. Just remember that you need to keep your withdrawal rate lower than the growth rate of the fund. So, keep a watch, else you will dip into your capital.

Two, the way to indicate risk in a mutual fund gets a major makeover. The existing risk-o-meter was poorly designed and did not build in all the risks investors are exposed to, nor was it dynamic. This is especially true of debt funds that can see the bond quality change drastically over time. The new improved risk-o-meter now has six categories of risk from low to very high. At 7 is the risk of overseas funds and exchange-traded funds (ETFs). This meter will get updated on a monthly basis and will be put up along with portfolio disclosure. Funds will disclose the risk reading on year-end and how many times it changed over the year. It needs to be prominently visible to investors. It comes into force from 1 January 2021, though funds can adopt it earlier if ready.

The big leap that this version of the risk-o-meter takes is that it pins down debt funds into a risk structure and makes the risk rating dynamic. Equity funds are easier to handle when it comes to risk, but debt funds have been perceived as “safe" and then investors found the risk of capital erosion embedded in some parts of the market. Debt fund events over the past few years have nudged the regulator into totally revamping the risk-o-meter. The changes are all under the bonnet and are quite well thought through. Debt funds will be evaluated on a mix of three risks they face—interest rate, credit and liquidity. Equity funds will be evaluated on market cap, volatility and impact cost. I am expecting third-party analysts to come out with risk boxes and then classify products that a risk-averse investor can choose out of. This will really clean up a lot of the miscommunication about higher returns without indicating the higher risk. You can read the 23-page circular here.

Three, inter-scheme transfers will be put in a straight jacket to prevent funds from mis-using the facility to park non-performing stocks, risky bonds and other unwanted securities in schemes that are not flagship, closed-end or largely retail. Inter-scheme transfers were aimed at allowing mutual funds to switch securities between schemes. But this has been mis-used to show performance in flagship schemes and move lower-rated papers into schemes that are more retail than institutional. The new rules will hold the fund manager accountable if a scheme so transferred has a credit downgrade within four months of the transfer. You can read the circular here.

It is unfortunate that the regulator has to resort to such micro-management. But some parts of the mutual fund industry leave it with no option as they use the letter of the regulation and not the spirit and continue the race for AUM garnering. After all their compensation and bonuses mostly depend on AUM and not performance of the entire basket of funds they run.

Source : Live Mint back