Switching securities b/w schemes in Mutual Funds

Similar to my last post where the post talk about ‘River crossing’ in Mutual fund industry, this article talks about MFs transferring debt securities from Fund to other Fund for liquidity reasons.

“There were 4,745 such transactions, called inter-scheme transfers, in fiscal 2016, the second highest since the financial crisis. These totaledRs.93,931 crore or 11.42% of debt assets under management.

Why is this important?

First, because FY2016 saw a record Rs.3.8 trillion of corporate debt downgrades, according to rating agency Crisil Ltd. Three fund managers that Mint spoke to said that transfer of papers from one scheme to another to tide over credit quality issues is the likely cause of the spike in inter-scheme transfers.

Dhirendra Kumar, chief executive officer of fund tracker Value Research said that it could also have been to meet liquidity requirements as investors switched between funds in line with a change in expectations of where interest rates would go, but added that turbulence in credit opportunity funds is also one of the likely reasons.

Second, the problem with inter-scheme transfers—as opposed to the fund house selling debt in the open market—is that there is some elbow room on the valuation of such securities since both the buyer and the seller are the same fund house. Fund houses were found guilty of using the route to transfer losses from one scheme to another in 2011 and investors had to be compensated for the losses they suffered as a result.

Capital market regulator Securities and Exchange Board of India (Sebi) said earlier in the year that it has noticed fresh irregularities.

“In some instances, we have also found that valuations and inter-scheme transfers are not exactly according to the Sebi requirements…I want you to note…that we are watching,” Sebi chairman U.K. Sinha said at a mutual fund summit organized by lobby group Confederation of Indian Industry in July 2015.

For mutual fund houses, it sometimes makes sense to switch papers between schemes rather than sell in the open market because they can save on transaction costs such as brokerage. It particularly helps if a debt security is difficult to sell in the market because of liquidity issues; it can simply be transferred to another scheme which has surplus cash and can invest in such securities. Globally, regulators frown on inter-scheme transfers, but the practice has just carried on in India.

“Inter-scheme transfer is not normally considered positive…(though)…it reduces the cost,” said Ramanathan Krishnamoorthy, chief executive officer at Spectrum Wealth Solutions, a boutique wealth management firm.

The last time there was such a spike in inter-scheme transfers was in fiscal 2011 (note that Sebi started collating data only since 2009). Then, a possible reason could have been a change in valuation rules. Sebi had then said that mutual funds must value securities which mature in over 91 days on a mark-to-market basis.

Earlier, the fund house had some discretion in terms of the price they valued the security at in their portfolio. Mark-to-market means that such securities would have to be valued based on their market value, making them more volatile.

Fund managers whose portfolios were hit by the rule change then could have resorted to inter-scheme transfers, said two fund managers, who declined to be named because of the sensitivity of the issue.

Now, with inter-scheme transfers spiking again, the regulator is contemplating action against malpractices in inter-scheme transfers. The Economic Times reported in February that Sebi was looking into it, particularly in the wake of credit-rating downgrades in Jindal Steel and Power Ltd’s debt securities.”


“River Crossing” in Mutual Funds

This economic times article talks about “river crossing” in mutual funds.

“River crossing, or parking or holding period return, is a rampant practice, which takes place mostly at the financial year end when mutual funds connect with cash-rich entities to tide over redemption pressure. Regulators normally consider the practice imprudent since it raises investor risk.”

“This time the redemption pressure was somewhat higher in the middle of the year, triggered by the Amtek Auto fiasco

In September, CD rates had spiked about 25 basis points across maturities as banks aggressively raised money to shore up their deposits ahead of quarterly earnings. But, this time, the rates slid following RBI’s borrowing cost reduction exceeding estimates.

At the same time, mutual funds, the biggest buyer of CDs, face redemption pressure in their liquid and ultra short-term funds as lenders want to avoid setting aside any extra capital for MF exposure to maintain a good capital adequacy ratio.

At this point, some intermediaries or brokers connect with a few cash-rich entities, be it corporates or bankers, which extend funding support to MFs by temporarily buying CDs at higher rate than normal.

Beginning next quarter (October), those financial entities sold back CDs to MFs at a predetermined price. The price is calculated in such a manner that the financing institute gains 10-20% annualised return for 5-10 days.

For instance, state-owned Syndicate Bank’s CD maturing mid-December has been traded at a high of 7.61% against a normal rate of 7.05% on October 1, said two market sources. On October 5, Andhra Bank and Axis Bank CDs yielded 7.63% each with both maturing in November-end.

“It is unwise for mutual funds to participate in this practice,” said Dhirendra Kumar, CEO of mutual fund portal Value Research. “The gains are few and if something goes wrong, the potential damage to reputation is immense. Showing higher asset for a few days can hardly be a big achievement.”

“Such practices could chip away at investor confidence just at a time when they have started reposing faith on the industry,” he said.

Selling and buyback of CDs at pre-determined rates are prohibited if reversal of trades are happening in the secondary at unusual rates,,” said a treasury head of a large bank.”

Simplification of Mutual Fund Plans

According to these article [1] , [2]  on Value Research SEBI is planning to ask the Mutual funds to simplify their plans and broadly categorize them into a small number of objectives. There are both pro and cons of this.

On the pro side it will help the investor by making different offering comparable. This will lead to increase in competition among Mutual Funds and improve their performance. On the other hand it can curb innovation. For example as discussed in this article Asset Management Companies (AMCs) are introducing funds which names having words like child care etc. These funds by invoking investor sentiment of children etc are trying to reduce the sensitivity of fund inflow to market conditions. Ultimately it is beneficial to both retail customers and the funds.

If the new regulation requires Mutual funds to not have more than one or two products in a given category then we might not see such innovations in future.

Side Pocket in Indian Mutual Fund Industry

This article says that SEBI is reluctant to provide rules for creation of side pockets.

“A side pocket is used by fund managers to separate stressed or risky assets from other investments and cash holdings. Fund houses create side pockets to ensure that while a proportion of investor money (in the scheme) linked to stressed assets gets locked until the fund recovers dues from a stressed company, investors are free to redeem the rest of their money if they choose to.”

The rational is that allowing isolation of risky assets from the rest fund would encourage fund managers to to take on more risk.

“Sebi is of the view that mandating the creation of a side pocket, to minimize the redemption pressure on the entire fund arising from their exposure to any particular company, could lead to some fund managers taking unnecessary risks,” said the chief executive officer of a large fund house, requesting anonymity. ”

However lack of rules can also lead to chaos and confusion among the mutual fund managers. Recently when Amtek Auto was downgraded JP Morgan had restricted redemption of Mutual Fund units and created a side pocket to isolate Amtek Auto from the rest of the portfolio.


Constituents of Mutual Fund industry

This article in economic times explains  the functioning of RTA  agents.

“Mutual fund investors do a number of transactions, like buying, selling or switching units. They could request for a change in bank details or address. Each such request is a transaction by itself. Mutual fund houses have to maintain records of each such transaction.

Mutual fund houses may not want to invest in these processes nor would they have the skilled expertise to handle these huge transactions on a professional basis. Hence, they would want to outsource this work to an agency, which can handle these requests from investors. The registrar and transfer agents (R&T agents) help them perform this job.”

Found this old article which gives a broad overview of the constituents of Mutual fund industry.

“In the US, funds are set up as investment companies which could be a corporation, partnership or unit investment trust whereas in the UK, funds are set up in two alternative structures-open-ended funds are set up in the form of trusts while closed-ended funds are set up as corporate entities. In India, all type of funds (whether open-ended or closed-ended) are set up as unit trusts. The structure is defined by Sebi (Mutual Fund) Regulations, 1996. The key constituents of Indian mutual funds are:

Sponsor: The sponsor is akin to a promoter of a company as he gets the mutual fund registered with Sebi. The sponsor is defined under Sebi regulations as a person who, acting alone or in combination with another body corporate, establishes a mutual fund. The sponsor forms a trust, appoints the board of trustees, and has the right to appoint the asset management company (AMC) or fund manager.

Trustees: The mutual fund can be managed by a board of trustees or a trust company. The board of trustees is governed by the Indian Trust Act whereas a trust company is governed by the Companies Act, 1956. The trustees act as a protector of unit holders’ interests. They do not directly manage the portfolio of securities and appoint an AMC (with approval of Sebi) for fund management. If an AMC wishes to float additional or different schemes, it will need to be approved by the trustees.

Trustees play a critical role in ensuring full compliance with Sebi’s requirements.

Asset Management Company: The AMC is appointed by trustees for managing fund schemes and corpus. An AMC functions under the supervision of its own board of directors and also under the directions of trustees and Sebi. The market regulator has mandated the limit of independent directors to ensure independence in AMC workings.

The major obligations of AMC include: ensuring investments in accordance with the trust deed, providing information to unit holders on matters that substantially affect their interests, adhering to risk management guidelines as given by the Association of Mutual Funds in India and Sebi, timely disclosures to unit holders on sale and repurchase, NAV, portfolio details, etc.

Custodian and depositories: The fund management includes buying and selling of securities in large volumes. Therefore, keeping a track of such transactions is a specialist function. The custodian is appointed by trustees for safekeeping of physical securities while dematerialised securities holdings are held in a depository through a depository participant. The custodian and depositories work under the instructions of the AMC, although under the overall direction of trustees.

Registrar and transfer agents: These are responsible for issuing and redeeming units of the mutual fund as well as providing other related services, such as preparation of transfer documents and updating investor records. A fund can carry out these activities in-house or can outsource them. If it is done internally, the fund may charge the scheme for the service at a competitive market rate.”



RTA scam

This article talks about a financial fraud which didn’t receive much coverage in the main stream media. Some more coverage can be found here. I have covered the functioning of an RTA in my other article here. However RTA can in general also provide service to companies instead of just mutual funds discussed in the article.

Shares/dividends can remain unclaimed because the initial owner might have died and his family might not have been aware of this; or forgotten; or the ownership documents might have been lost and the owner didn’t want to perceive it because of cost benefit analysis. At times the owner might decide against putting effort to en cash a small dividend.

When a fraudster becomes aware (usually with the help of employees of RTA) of any unclaimed shares/dividends lying around for a long period of time he produces fake documents and claims himself to be the rightful owner. As long as the rightful owners are not aware of this and don’t approach the company there is very little chance of catching these rightful owners. The only way is to put stricter norms for claiming the shares.