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.”

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.

Cheating small investors in Mutual Funds

This old article describes a way in which mutual fund distributors  and large investors collude to exploit small investors. Luckily SEBI has taken some measures to reduce this though.

“If the MF has spent 5% of the new fund raised towards the above expenses, effectively only Rs 95 of every Rs 100 will be available for investment. Rs 5 is treated as “asset” for the purpose of computing net asset value (NAV) and is amortized over a period of five years. In open-ended schemes, investors can enter and exit at will.

Such frequent transactions lead to transaction costs, the need to keep some funds in cash (an inefficient form) and liquidity risks or that of the availability of opportunities. But, a survey of entry/exit load structures indicates that, by and large, all funds tend not to charge either entry or exit loads on investments over Rs 5 crore.

Let us examine how this bias works. Suppose, a MF has collected Rs 100 crore and issued 10 crore units of Rs 10 each by spending Rs 5 crore towards marketing the issue. About Rs 30 crore is invested by four investors with an average investment of Rs 7.5 crore.

If there is no exit load, these four investors are free to exit any time at the prevailing NAV. If they exit in two days after the allotment without paying an exit load, the remaining unit holders will have to bear the expense towards marketing activities. The Rs 5 crore will be spread over Rs 70 crore instead of Rs 100 crore.

If any investor with an investment of under Rs 5 crore exits at the same time, s/he will be charged a proportionate cost of the marketing expenses or exit load. Besides, distributors who earn commissions of up to 4% of the funds raised often share this commission with large investors.

This practice induces “flight of investments” from one new fund to another as it is beneficial to both parties, even as the smaller investor suffers silently. The reform introduced by Sebi in the rationalisation guidelines simply puts a full stop to this practice.

They effectively force MFs to levy entry/exit loads on every investor that enters/exits a scheme or absorb the expense in to the fee charged by the MF scheme towards fund management. The new rules subtly introduce a cap on marketing and distribution expenses.

Funds that intend to charge higher entry/exit loads will not be able to garner subscriptions due to which they would like to keep them as low as competition permits. The ability of distributors to demand and extract higher commissions from fund houses will substantially diminish since a MF cannot pay more than the loads collected from investors.”