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.”

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Author: Bobbur Abhilash

I am a fourth year Doctoral student in the Finance and Control Department at IIM Calcutta.

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