MutualFunds

SEBI has gone from seeing things in black-and-white to now, colour-coded mutual funds. It has, in a circular, asked all mutual funds to colour code their funds blue, yellow or brown according to their risk levels (low, medium or high respectively).

This is a great source of revenue for all the printers that currently print their brochures, memorandums and information booklets. This is not a good day for trees.

Much as I may joke, a concept like this can actually be useful. Once, while filling tax returns, the forms were colour coded, and it made life very easy for all of us. Individuals got one colour, companies another, those with business income in a proprietorship yet another, etc. But that made a difference only since the ENTIRE form was that colour. I doubt having a little square box will make a meaningful difference.

All funds should have a single box with three attributes:

• long term growth or short term income (or any other combination of the term/goal)
• objective of the fund like we intend to mortgage your children to pay for our beer, or more realistically “ investment in equity and equity-related securities including equity derivatives of
  top 200 companies by market capitalisation.”
• The “risk” with the colour box (Low risk, Medium Risk, High Risk) )

My notes:

• The products will still be mislabelled. Is an FMP that invests in short term corporate debt low or high risk?

• Investors understand risk in mutual funds. In fact they overestimate it. People tell me mutual funds have high risk, even those that invest in short term g-secs, the lowest risk product available) So I’m not sure who will benefit.

• I would recommend that such labelling be carried over to all fin products. Insurance, bank deposits and even ETFs (on their web pages). What’s the point of doing this only for Mutual funds?

• Who prints the stationery really? Are they public?

SEBI has made misselling a fraudulent practice by adding a clause into the "Prevention of Fraudulent and Unfair Trade Practices" Regulations, via a notification:

(s)  mis-selling of units of a mutual fund scheme;
Explanation.- For the purpose of this clause, "mis-selling" means sale of units of a        
mutual fund scheme by any person, directly or indirectly, by─ 
(i) making a false or misleading statement, or 
(ii) concealing or omitting material facts of the scheme, or
(iii)concealing the associated risk factors of the scheme, or
(iv) not taking reasonable care to ensure suitability of the scheme to the buyer.

At first glance this appears to be a far reaching addition because you can hardly prove (or disprove) such an allegation when it occurs. Did the agent conceal a material aspect of a scheme? How can you prove it if he said he did reveal it?

The last bit (ensuring suitability of the buyer) seems even more subjective, but I suppose it could be on a "reasonable effort" basis where you can only get rapped in a very extreme case.

Having gone through the rest of the "fraudulent" practices, it seems we do have a framework of subjectivity. For example:

(b) dealing in a security not intended to effect transfer of beneficial ownership but
intended to operate only as a device to inflate, depress or cause fluctuations in
the price of such security for wrongful gain or avoidance of loss;

You could easily state that most intraday "strategies" of a large size will qualify. However I believe the framework is subjective because it needs to be so: given the range of appeals available (SAT, courts) it is better to have a law that is broad and subjective, rather than create a tight and restricted rule which the big and bad jokers will easily find a way around.

So overall, I don't find it such a bad deal to not have a strict definition of what misselling is. What I would like to see, however, is that SEBI investigates cases, and has HUGE penalties on extreme forms of fraud of any sort, including jail time.

Today, fraudsters get away with small fines and a small period of a ban on trading. That should not be the case. If we want to deter other people from a crime, the punishment should be huge and visible. That means when they catch the big frauds, those people need to go to prison. We need to see people banned for life from the markets. We need to see fines that are so heavy they will leave the fraudsters with nothing - I mean, for a fraud of Rs. 100 cr. we should see fines of Rs. 500 cr. as punitive damages.

In this respect, if a bank is found to be selling equity mutual funds to old women who come in looking for a deposit, I think the bank should be fined a minimum of Rs. 10 cr. as a deterrent. Banks seem to have the most serious offences of misselling agents who pose as "relationship managers".

Misselling may be provable only in an extreme case, and with respect to mutual fund selling I think it's difficult to prove either side. Online players need to be careful; they must provide all information available (risk factors etc.) and have some defence available to state that they tried to provide "suitable" products for a buyer. For others, agents have to be careful to reveal such information pro-actively.

I don't believe this regulation changes much: misselling in mutual funds has been cut down since SEBI removed entry loads and the new offer frenzy died. But I would welcome something similar in insurance and banking.

In the latest SEBI board meeting, a few norms have been discussed that will change the world of mutual funds and personal advise. Note that the actual circulars to implement these changes will follow. (I waited a week, then I decided this post had to be made) A few points that make the grade:

Mutual Funds To Have More Flexible Expense Ratios

Asset Management Companies (AMCs) have complained that they are restricted in how they can use their expense ratios. SEBI has now allowed "total fungibility" in such expenses; only the total number can't be greater than 2.5%. Earlier they had fees of about 1.25%, other charge

And it *can* be greater than 2.5%. Upto another 0.30% is allowed if funds flow in from beyond the top 15 cities. Note that this doesn't mean expenses will go to 2.8% - if funds have to remain competitive they must not load the expenses too much; so they will likely still stay around the 2% level which they currently are.

There is a problem - in that the top 15 cities account for over 85% of assets in the MF industry. But it's further skewed than that. Nearly 45% comes from Mumbai, and more 70% comes from Mumbai and Delhi.

Further, the top 15 cities keep changing every quarter. Gurgaon was #16 in terms of total AUMs in the Jun 2012 quarter. However, one quarter earlier, it was 14th. I wonder how these things get taken care of. In the 6-monthly disclosures, AMCs need to mention what they are doing to broaden geographical penetration.

Finally, Any service tax charged to the AMC for the scheme was borne by it. Now that can be transferred to the scheme (meaning, investors will pay).

Exit Loads to be Ploughed Back

If you exit a fund early, you may be charged an exit load (usually 1% in equity funds within a year, lesser in debt funds). This money was used by the AMC however they wanted; for paying distributors commissions (an upfront commission could get adjusted this way) or for extra fees.

Now, such loads must be credited back to the scheme. So as an existing investor you will benefit when other people leave early! Bad for the AMC and for agents - they will get compensated lesser.

The Lower Expense Ratio Plan - Direct

All plans of the same scheme (Institutional/Retail etc) will now have the same expense ratios. (So there's no lower expense ratio for institutional etc.) But there's one difference: DIRECT plans - where there are no distributors - can be created with lower expense ratios.

This makes sense. Where an investment is directly done by the investor - either by studying the market himself or after following advise or buying online - there is no need to compensate a distributor at all. Agents in equity funds get upto 0.5% per year as "trailing" commissions - if you consider that you make 10% a year, Rs. 500,000 today will grow to Rs. 25.93 lakhs in ten years. At a lower 0.95% per year, you will make 24.78 lakhs - a difference of about 1.15 lakh.

Distributors are crying hoarse that this will hurt their business as investors will choose to go direct. And that this does not benefit the industry. I strongly disagree. Firstly, most distributors - even those I have interacted with - provide very little value addition beyond the initial transaction. They take the cheques, fill the forms and might call you once a year. For that, you don't pay them 0.5% a year. Some say they provide advice - but they should charge separately for that advice, and this is the concept of why entry loads were removed in the first place. And if they do provide advice that is of at least some value to an investor, the investor should be happy to choose a "non-direct" scheme with slightly higher charges. Come on - if the value you provide gives no perceptible benefit to the investor, then you should not be compensated in an underhand way through higher expense ratios and trailing fees.

Second, there is an obvious benefit to the industry. Most of the corporate money into liquid and debt funds is placed directly with fund houses. Boards will likely dictate that money goes only into direct-only schemes. Of the total 6.89 trillion rupees (689,000 cr.) in mutual funds as of Jun 2012, more than 4.7 trillion (68%) is in income and debt funds; and corporates account for 43% of mutual fund assets. If you consider Rs. 2 trillion on which just 0.1% trail loads are paid which can move into a DIRECT scheme, that's a saving of Rs. 200 cr. Most of this money, today, goes into the pockets of large banks who are distributors. 

The other benefit is that you have lesser issues with direct schemes - that is, investors can't complain that distributors misled them or such.

What should happen now is that to make things easier, CAMS and Karvy should come up with a single customer login/password so they can buy any fund directly. That will make things really simple. (And then, most money seems to come from the top few cities, which can easily use the internet and migrate to direct).

Anyhow, this is a sour point for distributors (who will lose the argument since it's good for investors) and for AMCs who will now have to directly service customers.

Brokerage Capped at 12 bps and 5 bps

Brokers will be unhappy. From earlier charges of 0.20% (20 bps), mutual funds can't pay more than 12 bps (0.12%) for stock transactions and 5 bps (0.05%) for derivatives.

Regulated Advisors

People who provide financial advise for a fee will have to go through registration and provide information to SEBI. The regulations aren't yet out (there were drafts earlier) but it seems like people will have to prove they are capable of providing advice, track their customers etc. Such people cannot get paid from Mutual Funds (for trail fees etc.)

There are exemptions - people who give free advice in a broad media (so this blog author will be exempt), stock brokers, AMFI agents (who don't charge a fee for advice), insurance agents etc.

Other Changes

• AMFI Fees for distributors will be reduced
• Upto 20,000 investments in cash will be allowed
• IPOs can have less than 20% owned by promoters, if the rest is contributed by VCs or PE funds.
• A new format of disclosure like the 20F form by SEC will be created. This is great - the layer of disclosure in 20Fs is much much more than currently given.
• Non Retail investors can't withdraw or change their bids in an IPO. Ooh.
• ESOPs can't buy shares in the market. (See My Article)