Mutual funds: It’s time for tight regulations

Mutual funds: It’s time for tight regulations

Until recently, mutual funds were in fierce competition with banks for people’s savings. Now, they are in deep trouble. Some of them are facing huge redemptions and looking for a lifeline from banks to stay afloat.

The banking regulator has opened a special window from where banks can borrow short-term money and lend that to distressed funds. The Rs60,000 crore credit window will remain open until 30 June 2009. But this particular banker is against extending a helping hand.

Mutual funds have all along been wooing bank depositors with higher returns, forcing banks to raise their interest rates. But, after paying tax, a bank depositor earns much less compared with returns from mutual funds. For instance, an investor in equity and balanced funds (equity and debt) pays only 10% capital gains tax on the dividend income and if the person stays invested for more than one year, the tax burden is nil. In contrast, a bank depositor pays income tax, depending on annual interest earned. Investors in debt and liquid funds pay tax on their income, but not as much as a bank depositor pays.

“I am not the one who will forget the past and throw a lifeline to them," says this banker. He is one among many bankers who do not seem too unhappy with the state of affairs in the mutual funds industry. But the bigger enemy of mutual funds is the industry itself. It has hardly done anything to build itself except for being used by cash-rich corporations as a vehicle for tax arbitrage.

India’s first mutual fund, Unit Trust of India, was set up in 1963. Twenty-four years later, in 1987, SBI Mutual Fund was born, marking the entry of the public sector into this business, and by 1993, when the industry was opened to the private sector, its assets under management was around Rs47,000 crore. Fifteen years later, with 35 asset management firms offering at least 1,000 schemes, the size of the industry is about Rs4 trillion, less than 12% of banking assets.

Apart from the fact that there are some 47 million account holders of mutual fund schemes, no other critical data is available about the industry that can help us track its growth and development. The Reserve Bank of India periodically updates statistics on the footprints of Indian banks across the country and the growth of bank deposits and loans in every state. But neither the capital market regulator that supervises mutual funds nor the Association of Mutual Funds in India, or Amfi, the 13-year-old industry lobby, has any data on the investor base of the industry.

The capital market regulator has recently banned early exits from close-ended funds to stem premature withdrawals. Close-ended funds are schemes that raise a fixed amount of money through an initial fund offering. These schemes, some of which are listed on stock exchanges and traded, don’t accept investments once the offering closes. However, many such funds are not strictly close-ended because they allow premature exits by investors.

The industry has seen at least Rs1 trillion worth of redemption since mid-September. Premature exits led to a distress sale of assets, leading to losses for fund houses and hurting long-time investors. The regulator has also made listing of all close-ended funds on the stock exchanges mandatory, offering an alternative exit route for investors.

But these changes smack of a band-aid approach; the industry needs tighter regulations in many areas. For instance, there is no regulation of asset concentration. So, a scheme can be overexposed to a particular sector and the investors run the risk when that sector is in trouble. There are no checks on the quality of assets, too. Normally, the fixed-maturity plans, or FMPs—the debt schemes that invest their corpus in fixed-income securities—promise certain types of securities, but often there is a difference between what they promise and deliver.

The biggest problem of the industry lies in distribution of mutual fund schemes. Unlike insurance products, where the distributors cannot sell more than one firm’s policies, mutual fund distributors have no such restrictions. They offer a bouquet of products, but push those for which they get the maximum fees. The regulator allows mutual funds to spend 6% of a scheme as marketing expense and a large chunk of this is spent on pampering the distributors.

And the distributors can take investors for a ride as the industry is not interested in educating them. The ministry of company affairs has set up an investor education and protection fund using the unclaimed dividends of firms. The corpus of this fund is at least Rs750 crore, but it does not spend more than 1% of the amount a year, conducting workshops and panel discussions on financial literacy. The ministry should transfer the money from the Consolidated Fund of India to the capital market regulator for investor education. The mutual funds, too, have their share of unclaimed dividends that can be used for this purpose. The industry is not showing any interest in investor education because it gets the bulk of its money from corporations. But it must remember that without educating them, it cannot woo retail investors.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to