The regulations that govern the operations of mutual funds in India are about to undergo some significant changes. This was inevitable, considering the nature of the crisis that the industry has undergone. While the exact nature of the changes are not yet decided, the underlying theme will be that of protecting and enhancing the 'mutuality' of mutual funds. What exactly is this 'mutuality'? This is a concept that investors and--even fund professionals?do not recognizable explicitly. However, it lies at the heart of the very concept of a mutual fund.
The principle is that all investors in a fund must be equal partners in it. There are two sides to this. One, the fund company must treat all of them equally. And two?and this one is harder to achieve in practice?funds must be run in such a manner that the actions of one investor can not harm another.
The crisis that funds faced over the last few weeks appears at first sight to be about funds being unable to make redemptions when asked for because of the credit crisis. However, at a more fundamental level, the problem was that of a massive breakdown of the mutuality of the funds. When some investors show up to ask for early redemptions in the midst of a massive credit freeze, then the only way to meet their demands was to sell of the more sellable investments at whatever desperate price they would fetch. In a crisis, it's always the better investments that are more sellable. Were this to be done, then the some investors?the early redeemers?would walk away with some of the returns that actually belong to the ones who stayed on.
This time around, the extraordinary and global nature of the crisis meant that the government made special, once-in-a-lifetime arrangements to enable funds to make redemptions without having to sell off investments at fire-sale prices. The government arranged for bridge loans that enabled funds to make redemptions and yet delay sale of investments. However, in more normal circumstances, many things can happen that lead to similar situations.
One of the solutions that have been proposed is the strict isolation of corporate and individual investors. The idea is that the two kinds of investors should not invest in the same funds?fund companies should run corporate and retail versions of the same funds. This is in fact already done in some funds although in those the motive seems more to protect corporates from the high cost of servicing individuals rather than to protect individuals from the adverse affect of corporate's sudden redemptions.
In principle, the idea of isolating the two kinds of investors is a sound one. The mutuality of mutual funds is easier to maintain if there is reasonable similarity in the nature and motives of investors. However, in practice there is a limit to how much such isolation can be achieved. There are plenty of differences of scale and goals even among corporates and individuals for this not to be a perfect solution. In fact, such issues have come up in the past too. As a result, there was a rule made a few years ago that no fund could have less than twenty investors or have more than a quarter of its assets from a single investor.
The main concern in all of the above is that when some investors redeem their money, then quick sales lead to the portfolio getting degraded. The ideal thrust of the new regulations should be to make sure that investors' investment and redemption cycles should reflect the actual liquidity of the underlying assets. If there's a mismatch between the two, then all the rules in the world will not prevent a breakdown of mutuality.