Home / Opinion / Views /  Opinion | Mutual funds deserve tougher supervision

The capital market regulator has acted fast to get regulations up to speed with a wily mutual fund industry that has for long been used to stretching, bending and disregarding outright the spirit of the law. At its 27 June board meeting, the Securities and Exchange Board of India (Sebi) put in place tighter rules to curb the misuse of debt funds by some fund houses to offer higher returns to their corporate, bank and insurance company clients, in the process putting retail investors’ money at huge risk. Some debt funds have seen more than half their value wiped out over a short time, shocking investors, regulators and analysts alike. This kind of value erosion is expected in equity, not debt. Debt funds offer higher returns than fixed deposits to low-risk investors by playing on duration and credit quality. Duration is nothing but the call a fund manager takes on the direction of interest rates, and, unless the manager is clueless, there is a low probability of investor money being threatened by a wrong duration call. But mutual funds have sought higher returns perilously often by taking on credit risk, done either by buying lower-rated bonds issued by private firms, or striking specific—sometimes bilateral—deals with borrowers (cutely called “credit enhancement") that could cause a spike in the risk borne by debt portfolios.

Sebi’s board has cleared several evidence-based and well-debated proposals that affect liquid funds in particular and debt funds in general. Liquid funds—those that invest in debt paper with maturity of up to 91 days—are a way for investors to hold short-term money (say, for needs that arise within six months). But Sebi found that liquid funds were being used by corporate clients of funds to churn their money overnight. Institutional investors seek higher returns, and to get their business, some liquid funds were holding very few (just 3% of the total in some cases) safe bonds such as government securities. Such safe and liquid securities provide mutual funds with assets to sell when faced with redemption. By fixing 20% of holdings as a minimum for such risk-free paper, Sebi has reined in cowboy fund managers, while leaving untouched most of the industry that was following this prudent practice anyway. To prevent the misuse of liquid funds for overnight money churning (there exist lower-return ‘overnight funds’ for that), Sebi is putting in place a sliding-scale exit load (to be borne by investors) that reduces as the investment reaches day 7. Retail investors who use liquid funds for short-term needs will not be affected. Liquid funds will also not be allowed to invest in short-term deposits and bonds that have structured obligations or credit enhancements. Sebi had found several fund managers stuffing liquid funds with very high-risk credit enhancement deals to bump up returns; such playing with fire is not on. Pushing the entire debt market to operate on mark-to-market numbers, with only listed paper allowed, will also assure investors of their money’s safety.

Sebi has done well to tighten regulations after taking a close look at some dodgy practices in an industry whose main offering is heavily being marketed to Indians as an ideal investment to balance risks and returns. Too many had gone along with “mutual fund sahi hai" (is just right), only to find to their horror that this ad line was misleading. If industry pushback has been muted, it’s largely because Sebi is empowering its smart young teams to use data modelling to spot problems and suggest regulatory changes. That’s good.

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