As the entry level vehicle for first-time investors in the securities market, mutual funds (MFs) have, over the years, discharged their functions responsibly. Therefore, any blowout in one or more schemes of any MF, gives rise to apprehension and anxiety. The protestations of the MF industry that one isolated incident should not lead to decreasing confidence in the industry, is not bought into by several investors, who for long have believed that nothing can go wrong with MFs.
At a roundtable organised by Excellence Enablers (www.excellenceenablers.com), a corporate governance advisory firm, several issues, concerns, suggestions and solutions surfaced.
There are two warnings which the MF industry has been putting out over the years. The first is “Mutual funds are subject to market risks. Please read the offer document carefully before investing”. The second is the proposition that “Past performance is not a guarantee of future returns”. If the problems disappeared with these two cautions, the industry would have been a better place.
However, in pursuit of the goal of delivering better returns than competition, many fund managers have, over the years, resorted to aggressive investment practices that, luckily for them, have not gone horribly wrong. In the recent high-profile meltdown in a few schemes of the Fund house, the root cause has been identified as the aggressive investment style of the fund manager, straying into areas where angels (read other fund managers) fear to tread.
So long as the returns are right, no one ever complains. The fundamental principle that “the higher the risk, the higher the reward”, or, to turn it on its head, “the higher the reward, the higher the risk”, is either not understood or is ignored.
Over the years, SEBI has mandated several risk-management practices, including, but not limited to, the management of liquidity risk. It must however be recognised that a Regulator cannot, and should not, micromanage investment decisions, and should merely ensure that they are consistent with the stated investment philosophy.
Oversight, on a continuing basis, is something that cannot be ignored, and this is where Trustees come into the picture. The Trustees are the custodians of the Funds, and it necessarily becomes a significant part of their responsibility to ensure that fund management is carried out in a manner that does not put at risk the funds invested in various schemes. For a number of reasons, Trustees, by and large, have been found to have not measured up to expectations.
Selection of trustee
The first element, in this complex structure-derived problem, is that the AMC has a significant role in selecting the Trustees. At a basic level, this corresponds to students in an examination hall selecting their invigilators. The theory, of course, is that Trustees select the AMC, which manages the fund, and are empowered to the extent of being able to change the AMC, and to bring in a new fund management team. However, when Trustees are appointed by the Sponsors, whose influence is significant on the AMC Board, it would be futile to expect that Trustees can, without reservation, call the shots.
The Trustee Board, which has the function of oversight, consists of independent Trustees and non-independent Trustees. The latter category normally includes representatives of Sponsors, as well as a representative of executive management. Given the role and responsibilities of the Trustees, there is a legitimate expectation that they will provide first level regulation in the MF industry.
Either because of a lack of role clarity or because of not being adequately empowered situationally, Trustees have not been able to ensure that fund management is carried on strictly in accordance with the investment philosophy of the Fund house.
A part of the problem is that in the selection of Trustees, there is no way of ensuring that only persons who have a first-hand experience of the industry are persuaded to join the Board of the Trustee company. The MF industry being different from the other elements of the financial sector, it would be unfair to expect everyone with financial sector expertise, to hit the ground running on the Trustee Board of an MF.
The related issue is that these are part-time functionaries, who interact with the AMC Board and the fund managers mostly on the dates when the Board meets. The information asymmetry which they suffer from adversely impacts on their ability to provide the right kind, and the right extent, of oversight.
There is a related problem that investors in the MF industry experience. Their expectation is that the existence of a Trustee Board in an MF is a guarantee against any misadventure by the fund management team. It is when fundholders recognise the expectation reality-mismatch, that confidence in the industry tends to suffer.
Like most other activities, trusteeship in the area of fund management is a specialisation which by itself is a product of experience and expertise, and the consequent willingness to take up the role of a Trustee. In a few countries this realisation has led to the creation of professional trustee companies which, for a fee, enter into an agreement with the Sponsors, to carry out the functions of trusteeship, including fund valuation, fund auditing and fund accounting. With more and more investors taking the MF route into the securities market, it is necessary to seriously consider whether the function of trusteeship should be assigned contractually to professional Trustees.
Misconception about AMFI
There is another misconception which needs to be addressed. A number of otherwise well-informed persons believe that AMFI is a self-regulatory organisation (SRO) for the MF industry. AMFI was born as an industry body, to represent the interests of the AMCs. To expect an industry body to dispassionately and objectively discharge a regulatory function is a fairly big ask.
While AMFI might promote best practices, as many industry organisations do, it does not translate to self-regulation, without the element of enforcement tagged thereto. One possible way of taking advantage of the representative nature of AMFI is to split AMFI into two organisations, with industry concerns and development being addressed by one of the two entities, and regulatory aspects by the other entity. The FINRA model, a carve out of NYSE (with NASD associated with the new entity) would be worth pursuing.
Mutual Fund Sahi Hai is a persuasive and comforting comment. However, the rare instance, when reality seeks to disconnect with perception, could drive the fence-sitters away from the funds, and even from markets. That is a luxury which no market can afford.
The writer is Chairperson, Excellence Enablers and former Chairman, SEBI, UTI and IDBI