Mutual funds -- The devil is in the detail

Suresh Krishnamurthy

THE INDIAN laws and rules governing mutual funds have borrowed heavily from similar pieces of legislation in the US.

Over time, the framework of regulatory provisions of the US securities market has been put to test and, if found wanting, suitably amended. This would prima facie suggest that the Indian laws present a picture of stability, even if not superior to that in the US securities market. But for all the learning value that the US code offers, the Securities and Exchange Board of India (SEBI) has found it necessary to issue occasional clarifications to strengthen the degree of protection available to investors. Surprisingly, the clarifications too are based on the US laws, making one wonder why these clarifications were not incorporated in the first place.

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What ails the Indian legal framework governing mutual funds? A look at the US' Investment Companies Act of 1940 reveals that the Indian laws fail to go the full distance in outlining the intention of the law-makers in greater detail. Consequently, while the Indian laws are similar to their American equivalents, they are also fundamentally different.

This difference obtains in the definition of mutual funds and their function. While the Indian laws do not significantly weaken the protection available to the investor, the liberal framework provides fund managers greater operating leeway. Still, in certain areas, the detailed nature of the US laws appears desirable. This is especially true of disclosures.

The US framework

In the US, apart from the definition of close-ended and open-ended mutual funds, funds are also legally required to label themselves as diversified or non-diversified. A diversified fund invests not more than 5 per cent of the net assets in a single stock -- a restriction that applies to 75 per cent of the net assets. Almost all mutual funds in the US are diversified.

The registration statement of a fund in the US is also expected to more specific in detailing the investment objective. Notably, the industry concentration the fund proposes to maintain must be disclosed. Moreover, the investment policy cannot change without specific approval from the shareholders. Also, the specific name of the fund cannot be misleading.

In India, it is not necessary for mutual funds to disclose whether they are going to be diversified or focussed. Until recently, funds could also theoretically alternate between being focussed and diversified. However, a recent clarification that prohibits investments of more than 10 per cent of the net assets in a single stock has made diversification mandatory. The rule, incidentally, has swung to the other extreme.

The stipulation effectively prevents focus on a relatively smaller lot of companies or even temporarily taking advantage of an uptrend in individual stocks. The US model allows such concentration up to 25 per cent of the net assets. Incidentally, the Association of Mutual Funds of India also suggested that the US model be adopted but SEBI overruled this.

More important, offer documents in India can afford to be quite vague. A fund that promises to be sectoral can state in the offer document that it will invest in all the industry sectors in India. This has ensured that a life-sciences fund can invest in an engineering company, a petro fund in technology stocks, and so on. Essentially, the name of the fund could be misleading. This has also ensured that the investment objectives can be changed without notice to the shareholders.

Such a liberal framework provides greater room to the fund manager to improve on the performance of the fund. For example, the close-end fund ICICI Power and open-end fund Tata Core Sector diverged from their stated objective of investing in India's core sectors to include the technology sector. This was possible because the offer document definition of core sector included the technology sector. While this change did benefit the shareholders, it is not, in general, a desirable development. What if the change had proved detrimental to the shareholders?

Also, having allowed such changes in the past, SEBI may now have to contend with such developments in several technology funds launched in early 2000. Many of them seem diversified rather than industry-focussed and, in that sense, are misleading. And it is anybody's guess whether shareholders want it that way, and if it is beneficial to them. A more detailed legal framework appears essential to deal with these issues.

Disclosures

On the face of it, the Indian rules regarding financial statement disclosures are very similar to the prescriptions in the US. However, it must be said that they are only similar, and that the US requirement is far more detailed. An important disclosure that the Indian rules do not require of mutual funds is that on the aggregate value of purchases and sales.

The aggregate value of purchases and sales is an important parameter in calculating the portfolio turnover of a particular fund. While a higher portfolio turnover means higher costs, such as brokerage, the returns may not automatically be higher.

In fact, the portfolio turnover, compared across funds, would provide meaningful information that would help investors decide which funds to invest in. Unfortunately, the Indian rules do not require such disclosure. SEBI recently came out with a circular requiring half-yearly disclosure of select details on a uniform basis. But it has not mandated the disclosing of the aggregate value of purchases and sales.

Another lacuna in SEBI's framework is the disclosure of per unit statistics. The historical per unit statistics disclosed by mutual funds on a half-yearly basis is largely useless. The purpose of the statistics is to reconcile the changes in the net asset value between one period and another. For example, if the net asset value moves up from Rs 10 to Rs 20, the per unit statistics would be useful in finding out how much capital gains lead to the 100 per cent increase, what the percentage of expenses is, and so on. However, perhaps because of the lack of proper accounting systems, the statistics seldom chart out a clear picture for investors.

In contrast, a comparable offer document in the US sets things out clearly. Also, as they set the portfolio turnover rate, an investor can surmise if the fund holds on to the stocks for obtaining long-term capital gains or turns over the portfolio aggressively. In India, any investor has to largely operate in the blind, as regards these factors. All he gets to know in any meaningful manner, both before and after investing, is the performance of the fund, and that too, until recently without reference to any benchmarks. Only recently did the rules clarify that performance information should always be linked to a benchmark.

Other issues

Among other issues is the need for the regulation to take into account the mechanism for selling mutual funds, or for that matter any security in the country. Mutual fund selling in India is largely outside the framework of regulation. A broker can peddle a high-risk fund to an investor stating that it is low-risk, without the fear of being pulled up by the law. The caveat emptor rule operates.

Marketing through sales literature has been duly covered under the new advertising guidelines. However, broker representations are largely unchecked. The lack of regulation needs to be viewed in the backdrop of the growing plans of many brokerages to emerge as investment advisory services firms. Already, many firms provide this service to more than a few clients.

The potential for trouble needs to be viewed in the backdrop of two issues: a) the lack of necessary data on a fund's performance and b) the phenomenal amount of money mobilised in the first three months of the year by the initial public offers of sectoral funds. Without proper data to take investment decisions, investors are guided by brokers; this could create conflicts of interest.

Also, the massive amounts mobilised by mutual funds in the first three months, which would not have been possible without help from brokers, indicate that such conflicts of interest could lead to undesirable developments. Such a development in the instant case is that in almost all private sector mutual funds, the sectoral funds are much larger than their diversified counterparts, due largely to the inflows in the first quarter of 2000. However, whether this was because of questionable selling practices by dealers is not clear.

In short, there is need for regulation to cover these two aspects -- mutual fund selling practices and investment advisory services. In both instances, the American laws are well-defined and tested, especially by the events of the past two decades. It has to be debated if disclosure alone is sufficient. If that be the case, the disclosure norms need to be tightened further. However, it may be necessary to put in place a legal framework too. Given that the nature of mutual fund investments in India is fast changing with the advent of futures, options, asset-backed securities and so on, investors may feel the need for protection sooner rather than later.