Of late, Indian mutual funds have been in the news for all the wrong reasons, with allegations of front-running levelled against a fund manager of Axis Mutual Fund and a whistleblower letter doing the rounds on Aditya Birla Sun Life Mutual Fund.
While one doesn’t know enough yet to comment on the veracity of these allegations, this does shine the spotlight on the issue of governance at mutual funds. There’s a lot of song and dance on whether listed public companies are managed in the interests of their shareholders. But what about mutual funds?
MFs are essentially custodians of public money, where both profits and losses are entirely passed on to unitholders. I give money to a fund manager to deliver a certain return from an asset class. But I am paying a fixed fee to him which he gets whether he does better or worse than the market. This pass-through nature of mutual funds means that the unitholder is most affected when the fund is mis-governed or mis-managed.
The three-layer structure: Is it enough?
Whenever questions arise about MF governance, industry insiders bring up the three-layer structure that is supposed to ensure that unitholder interests are protected. So by SEBI regulations, every MF has the sponsor who has skin in the game, an asset management company (AMC) that manages your money with the help of a CEO/CIO and an entire team which reports to the AMC’s Board and then a separate Board of Trustees to oversee the two other entities. We also have SEBI inspections, internal audits, statutory audits and any number of compliance requirements.
The problem with all this is that while it sounds great on paper, in reality, it has some holes. For one, the Board of Trustees, made up of outside experts, can only act upon the information conveyed to it by the AMC or the management. It cannot be expected to be in the know of operational aspects.
I have seen the reports that go to MF trustees for their meetings and it will take an accounting and investment expert to figure out the hundreds of pages that are given to them. They have to be expert fund managers to understand what goes on. So effectively, Trustees come to know only what the CEO/CIO tells them. Trustees are also aware of investment decisions only AFTER they happen. They are not equipped or expected to understand the entire portfolio across schemes. Technically, the Compliance Officer is the bridge between the AMC, the Trustees and SEBI. But his pay cheque comes from the AMC.
If the Trustee layer is removed from the industry, the responsibility / accountability will squarely and fairly fall on the AMC. The way the industry functions, this may be appropriate.
But even apart from the Trustees’ role, the three-layer structure offers no safeguards against negligence or deliberate wrong-doing in the way investment teams in AMCs make their buy or sell decisions. Here are a few aspects to ponder.
- To prevent mis-management, there is a recording of all investment decisions taken by the investment team. Buy and sell decisions are supported by standardised research notes. But the issue is that many aspects of portfolio construction – why some stock and why not some other stock, why underweight or overweight on a stock or sector etc, are not recorded or communicated to the Trustees/Investors.
- This loose reporting structure does allow ‘motivated’ stocks to be bought and sold, as the specific reason for stock selection need not be given. A mutual fund keeps buying and selling stocks. If a bet goes awry it can always be attributed to a call that is mis-fired and not deliberate wrong-doing.
- Adding to the loose communication, is the fact that schemes have a lot of leeway, thanks to month-end portfolio disclosures and the room offered by SEBI categorisation, to own stocks that don’t fit into their mandate. If I want to deliberately accommodate someone by buying a stock that is not suitable for the scheme, no one is wiser. All these small acts ultimately result in pulling down the performance of the scheme. These are governance issues which truly impact investors adversely and may not be discovered or disclosed.
These loopholes can be addressed by MFs improving the quality of their communications with unitholders. While every fund house dutifully churns out weekly and monthly market views, factsheets and newsletters that devote pages to global macros, GDP, inflation and so on, very few explain their specific investment choices, portfolio additions and deletions, and underweight or overweight positions relative to benchmark. As an investor, this is what I would want to know. If you want to gauge if a MF is well-governed, this is one aspect to look at.
- Sponsorship of mutual funds by business houses is also something to discuss. When HDFC/Birla/Tata MF invests in any of the group companies (except when it is part of an ETF), there is always a question mark. It is not easy to justify inclusion or exclusion. For example, if the investment banking arm of a financial services group wants to earn a fat fee by placing some poor quality shares/bonds, the mutual fund arm can be a convenient parking lot. The RBI, rightfully, has kept business houses out of the banking industry, precisely to avoid such conflicts of interest. Unfortunately, SEBI has already opened the floodgates. It therefore falls to MF investors to assess the track record of the sponsor in complying with regulations, to stay off doubtful MFs.
- Front-running by some rogue elements in AMCs have been a problem for long. Front running impacts the investor, because buying every share at a rupee or two higher than its market price, means that the investor is footing the extra cost. This is a bigger problem when it comes to illiquid/mid-cap/small cap stocks where prices for individual trades can be way off the reported market price. There are no clear solutions to this, except a punishment that is so severe that it acts as a deterrent.
- We have all seen the enthusiasm with which the mutual funds put in their applications to some new-age IPOs that have sunk 50% or more from their IPO prices. The investment bankers ‘place’ the IPOs / private placements with institutional investors. In a bull market, there are ‘hot’ issues which give instant gains to the successful applicant, so every fund manager wants to grab as much as he can.
To keep the investment bankers happy, they have to apply for some known dud issues also, so that they are not neglected in the ‘hot’ issue. And with this thing called ‘anchor’ investors as a separate lure, it is a cozy nexus between investment bankers and fund managers. I would rather see the anchor investor concept being done away with and let the mutual funds put in applications like the retail investor does. Let there be clearly stated principles in EVERY scheme with respect to IPO investments.
- For a broker to get business from a fund house, he has to be ‘empaneled’ . It is up to the dealer/fund manager to decide which broker gets how much business. This is another Pandora’s Box. Apart from ‘research calls’ and ability to get meetings with companies, there are some financial standards which the fund house will have. In some cases, the brokers provide ‘soft’ commissions like providing expensive data packages, holidays and other gratification to the dealer/fund manager. This may not impact your NAV directly, but it does put the fund manager under some pressure to accept recommendations, block share placements etc from brokers. This is a universal phenomenon and not just in India. Even if there is legislation in place, it is not easy to establish that something less than ideal has transpired.
- Another big risk I see, especially the debt segment, is the exposure to the BFSI segment. There was no reason for the exception to the single sector limit to be extended to BFSIs.
- Small cap and mid cap stocks are a minefield. High impact costs, poor liquidity, issues of governance are but some of the problems. This segment is always vulnerable and no amount of legislation can stop wrong doing. When dealing with that segment, it is always Caveat Emptor.
- As a large institutional shareholder, the mutual fund is supposed to vote on company resolutions and speak up against poor governance in investee companies. These are important rights that can make a difference to the entire governance ecosystem, but fund managers in India are seldom vocal against management.
Governance at mutual funds: What can be done
Our mutual fund industry is well-regulated at the micro level. But there are still some things that I would like our regulators to consider:
- Mutual fund owners (AMCs) should not have other financial businesses. Investment management has to be a separate business, with no conflicts of interest. However much we try to regulate, there is always some loophole.
- Doing away with the Trustee structure. Pin the responsibility entirely on the AMC for mis-governance so there’s no passing of the buck.
- SEBI should allow mutual funds to buy and sell shares directly, without intermediaries. In the debt market, it has already happened. This will reduce interactions with brokers.
- The fact sheet on equity mutual funds, should also disclose details of stocks bought and sold, and aggregation of loss-making trades as well as profitable ones.
- On every stock or bond bought/sold there should be a rationale that is disclosed to the investors. This is already being done by some portfolio managers.
- A clearly stated policy on buying of IPOs/Private Placements.
- A limit on the number of schemes a single fund manager can manage, in conjunction with the corpus size.
Mutual funds are in the business of trust. As a regulator, the best way to ensure better governance is to keep entry barriers high so that the risk of frauds and wrong-doings are minimised. Micro managing processes is not a solution to this. The other aspect is the legal system. Punishment for white-collar crime is hardly anything in India. If someone has been guilty of wrongdoing, the minimum should be to bar the person from being ever employed in the BFSI sector.