The Hindu Business Line : Derivatives: Beef up the disclosures

AS usual, mutual fund industry practices are set to march ahead of regulations concerning disosures. The latest development concerns interest rate derivatives. Trading on interest rate derivatives is set to commence in India. Mutual funds have been allowed by SEBI to trade in interest rate derivatives with the purpose of hedging interest rate risk and for rebalancing the portfolios.

However, simultaneous amendments to beef up disclosure requirements are absent. An ordinary investor with even a reasonable knowledge about financial instruments may find it difficult to understand the implications of derivatives in an income portfolio.

Interest rate derivatives are likely to prove beneficial to mutual fund investors. Still, the suitability of an income scheme that invests in derivatives to the investor's requirements will need to be explained. Regulations concerning disclosures do not require that now.

As of now, regulations require the offer document to contain what is usually dismissed as `boilerplate'. Offer documents contain blanket statements indicating the fund will invest in interest rate derivatives. It will also explain how interest rate derivatives work. Offer documents of all income schemes contain virtually identical statements.

However, what is needed is how the fund manager intends to use interest rate derivatives and the checks and balances imposed on him by the asset management company.

Also needed are details in quarterly newsletters regarding investments made by the particular scheme in interest rate derivatives and their implications.

Importantly, regulations applicable as of now do not encourage mutual funds to discuss the performance of income funds in any detail. Even now, there is case for disclosures on the divergence in performance of the scheme and its benchmark.

The case will only strengthen when schemes invest in derivatives. Investment in interest rate derivatives is highly likely to lead to a divergence in the performance of the scheme vis-à-vis that of the benchmark index. For ordinary investors, it would be difficult to understand the divergence in performance, which the fund manager will need to elucidate.

Without SEBI's intervention, mutual funds are unlikely to embrace a culture of detailed disclosures. A prod from the regulator is needed.

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