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Mutual Funds are Properly Governed

The mutual fund industry, because of its transparency & liquidity, empowers the investor to exit immediately, if he finds a slip-up in governance

In the backdrop of scams that have surfaced in various banks, how does the governance structure in mutual fund asset management companies work? How is investor money protected (I understand the risks involved: blue, yellow and brown)? Please explain in layman's terms.
- Vijay Zanvar

The recent governance issues that have surfaced in the case of public sector banks relate to the key issue of bad loans. Top officials of the bank have been accused of accepting bribes to extend more loans to distressed companies and putting the bank's (and depositors') funds at risk. The officials have also reportedly promised not to classify the company as non-performing assets (NPAs) in the bank's books despite delayed payments.

If you are wondering if mutual funds too can resort to similar window-dressing of their books, let us assure you that they will find it extremely difficult, far more difficult than is the case with a bank.

Let us take the case of debt mutual funds, which are most similar in their underlying activity to banks. Debt schemes regularly buy debentures, commercial paper and other debt instruments from corporates, that is, they lend to these companies.

Now, can a mutual fund manager accept a bribe and buy a poorly rated instrument? Worse, can he load up the portfolio with such instruments, thus putting the investor's money at risk? Can he then 'hide' these investments through creative accounting?

The answer to all these questions is a resounding 'No.' The reasons for this are threefold. For one, all mutual fund schemes have to value their portfolio on a day-to-day basis and disclose a daily Net Asset Value (NAV) to their investors. SEBI also has strict rules on how each security is to be valued. Therefore, any NPA in a debt fund's books will immediately show up in its NAV on the very day the instrument suffers a default.

Whereas in a bank, the NPAs are disclosed only once every quarter in the bank's financial results. What is more, banks have had the option to keep bad loans off the books by offering to 'restructure' bad loans and classifying them as 'restructured assets'. Therefore, if a debenture in a debt fund's portfolio does suffer a default, the scheme cannot postpone disclosing this to its investors. It will show up immediately in the scheme's NAV, thanks to the high levels of transparency in the operation of mutual funds.

Two, the fund cannot afford to disclose an incorrect NAV because it offers every investor the opportunity to exit at the day's NAV (if it is an open end fund). That is, the fund house puts its money where its mouth is and offers to buy back units at the value that it discloses. Now, debt funds usually tend have a number of institutional as well as informed investors. If a fund's NAV suffers a sudden blip due to default in one of the instruments, they will be bound to notice and rush to pull out their investments.

If the fund loses assets, that automatically impacts the profits to the Asset Management Company (AMC), In contrast; a loan default may not affect a bank CEO's salary! After all, an AMC's fees are a direct percentage of the assets under management. But it needs to be said that the current valuation and accounting norms for mutual funds have not cropped up overnight. They have evolved over the last 20 years as a result of learnings from several crises.

In the rare cases where delays or defaults do occur, it has become expected practise that the AMC will take the losses on its own books, rather than pass it on to investors and suffer reputation damage. But this may not be the only aspect of governance in a mutual fund. What if the sponsor or portfolio manager embezzles money? What if fund managers use the fund's activities for personal profit?

Well, the first kind of problem - that of misappropriation of funds, has been addressed by SEBI by having a three-tier structure for fund governance. A sponsor sets up a mutual fund and hires an asset management company. The sponsor is then required to report to Board of Trustees who independently oversee the fund's operations. They have a fiduciary duty to investors, to dismiss the AMC or pull up the sponsor if they observe any irregularity in the fund's operations. Fund houses are also subject to regular return filings with SEBI as well as audit by an independent statutory auditor. Thanks to this structure, India has only faced one instance of a significant governance problem with a mutual fund (CRB Mutual Fund) since SEBI became the sector regulator in the nineties.

Yes, SEBI has unearthed the occasional instance of insider trading (Alliance Mutual Fund in the 1990s) or front-running of the fund's trades (a dealer with HDFC Mutual Fund in 2007). But this was detected with the help of the stock exchange surveillance mechanism, with SEBI immediately initiating action against the employee or fund house in question.

This just goes to show that however water-tight the rules for governance in a particular sector, they can always be undermined through human greed or error. At least the mutual fund industry, because of its sheer transparency and liquidity, empowers the investor to vote with his feet and exit his investment immediately, whenever he finds a slip-up in governance.

Blast from the past
In the aftermath of the 2008 credit crisis, debt mutual funds in India did face a crisis, where realty companies whose debt instruments they held, defaulted on their payments.

Lotus Mutual Fund, which then held such paper under its Fixed Maturity Plans (FMPs), was forced to disclose this and was faced with a deluge of redemption demands by its investors. Following this, the fund was actually forced to shut down its India operations and make a distress sale of assets to the Religare group.

That episode not only prompted SEBI to tighten the rules for FMPs (it tightened valuation norms, banned indicative returns and premature exits), it made all debt funds move to the other extreme. They turned ultra-cautious about the choice of their debt instruments. Today, you will find that most AMCs do not venture below sovereign or triple A rated instruments in most of their debt schemes. Even investment-grade AA instruments are added only if the fund specifies it in its offer document.