Last week, there was news of a SEBI recommending that the minimum net worth for mutual fund companies be increased from the current Rs 10 crore to Rs 50 crore. While this move has obviously been demanded and welcomed by the bigger mutual funds, I'm unable to see it achieve any outcome except to make the bigger fund houses a little safer from smaller competitors.
The main reason for this increase is that fund houses need to have enough capital to absorb shocks of the kind that were faced by them during the liquidity freeze of October 2008. This is a strange argument because it legitimises a scenario whereby a fund house will use its own capital to either smooth returns or fill in liquidity in its funds. This is a slippery slope because it completely nullifies one of the basis of the very concept of a mutual fund-that it is a pass-through vehicle which simply provides investment management services for its customers. All the risks and losses must be customers' alone.
To accept that the fund house's capital should be a factor in managing liquidity and other market-related problems immediately raises the question of the logic of this particular figure of Rs 50 crore. Why 50 crore? During October 2010, if the liquidity crisis had to be managed by using AMC's capital alone then hundreds or even thousands of crore may not have been enough. At the time, this pass-through nature of funds was not maintained. To manage the crisis, the RBI opened a special financing window for funds. Also, some fund houses' parent organisations were said to have helped. It is notable that all the problems arose in debt funds because of the freezing of the debt markets, something that was a global phenomena at the time.
After the crisis, SEBI has gradually tightened many rules that make debt funds better aligned to underlying markets. These changes have generally been well thought out and thorough. However, investors should not get the idea that if either the equity or the debt markets freeze up--or even if one particular security has a problem, then the risk is there's alone. Anything else would basically convert funds into banks. If the funds' capital has to stand behind the investor, then they've really become banks and SEBI should hand it over to RBI so that CRR and SLR can be applied to funds too.
Actually, that points to another flaw in this net worth argument. If the net worth is needed to back up a fund, then surely it must be proportional to the assets being managed by an AMC. It hardly makes sense for AMCs at two ends of the size spectrum--the Rs 1.11 lakh crore Reliance Mutual Fund and the Rs 103 crore Quantum Mutual Fund to both need Rs 50 crore of net worth. My suspicion is that the bigger fund companies are so enthusiastic about the net worth being raised simply because they would like to narrow the competitive field in terms of fund performance. Some of the smaller AMCs have funds that routinely generate better returns than those from the big AMCs.
Mutual funds are generally quite a well-regulated field. Since the collapse of CRB Mutual Fund in 1996, SEBI has ensured that there's no one in the fund business who's going to run away with investors' money. Increasing the net worth requirement will not do anything tangible to increase investor safety. However, it will definitely increase entry barriers in a field that needs more competition.