VR Logo

Guarding Ignorant Investors

Many of Sebi's latest regulatory changes in the mutual fund domain attempt to protect investors from their own lack of understanding

Last week, SEBI published a circular with a range of changes in the rules governing the operation of mutual funds. Even though there were as many as six different changes that were made, there isn't anything much that would directly impact mutual fund investors. From an investors' perspective, the most interesting were the changes regarding New Fund Offers.

Unlike stock IPOs, mutual fund IPOs stay open for long periods of time, sometimes 30 or even 45 days. SEBI has now asked that this be shortened to 15 days. The reasoning behind this is that over a long period during which the issue is open, investors who apply early in the period find their money locked in unproductively. In the same spirit, SEBI has extended the ASBA (Applications Supported by Blocked Amount) system to mutual fund NFOs. In ASBA, investors apply for IPOs while the application amount stays in their own account and is just blocked from other use. The issuer is able to withdraw the amount when it allots the shares.

Although these changes sound like a significant reform to those who don't invest in funds, they don't really change much. A vast bulk of investors put in their investments during the last day or two of NFOs anyway. And as far as ASBA goes, it matters a lot in IPOs because allotment is not assured. The problem that ASBA solves in IPOs is that of investors getting a refund of the money quickly. In mutual funds, all the money that an investor applies with is eventually going to get invested into the fund anyway.

Of the changes announced last week, another one that could impact investors is the one concerning the paying out of dividends from mutual funds. While the change in the dividend rules sounds like an arcane accounting change, the principal behind it is very simple. Basically, SEBI doesn't want mutual funds to pay dividends out of funds deposited by investors, but only out of the returns earned by the funds. Mutual funds routinely use dividends as a marketing tool. Fund marketers know that investors are attracted by dividend payouts.  In fact, most of them have thumb rules, that estimate the quantum of fresh assets that can be garnered in relation of the dividend paid out.

SEBI's new rule may well limit the dividend-paying ability of funds. Moreover, even though the SEBI circular doesn't explicitly say so, one can assume that accounting rules will apply distinctly to the various dividend and growth plans of fund schemes. This would probably see the dividend plans of many funds running tight on distributable gains even if the growth plans have enough. All in all, there would be many situations in which funds can't distribute dividends as liberally as they would want to encourage fresh sales, which seems to be SEBI's intention.

Off course, the underlying problem is the use of the word 'dividend'. In a mutual fund, the word 'dividend' has a completely different meaning than in corporate finance, and investors' irrational attraction to dividend arises from this misnaming. In stocks, dividend is distributable profit while in funds, it's basically just a redemption of funds that belong to the investors anyway. The value that is distributed as dividend is simply deducted from NAV. In terms of returns, there is absolutely no difference between an investor receiving a dividend of a certain amount versus requesting redemption of the same amount. If investors at large understood this point, then the problem wouldn't arise at all.

Conceptually, many regulatory changes amount to protecting investors from their own lack of understanding. Nothing wrong with that-that's what regulations are supposed to do as every investor can't be expected to understand everything. However, it's a little sad to see nothing but lip service being paid to dissemination of investor education.