Big Story | How SEBI’s recent moves make mutual funds more investor-friendly

The past two years have not been easy for mutual fund investors.

Many debt funds that were marketed as products similar to fixed deposits with higher returns, have seen credit-rating downgrades of debt papers eat into their returns in several cases.

And the pandemic saw equity markets see-sawing dramatically, proving once again that guessing market moves can never be one’s cup of tea.

Assessing the risks inherent to mutual fund investments has proven a tough challenge for investors.

The securities market regulator SEBI’s recent moves — revised measure of risk, stricter norms for inter-scheme transfers and renaming of dividend schemes — are aimed at better identifying the risks in mutual funds and also bringing in greater transparency for investors.

Gauging risk in mutual funds

‘Mutual funds are subject to market risk’ is a message that has been drilled into investors’ minds for a long time. But what should matter to investors is the extent of that risk — low, medium, high or even very high.

Under the existing system, risk in a mutual fund scheme is assessed based on the risk to the principal.

That is, the risk level of a scheme depends on the fund category to which it belongs.

For example, a liquid debt fund falls in the ‘low-risk’ category. A large-cap equity fund is labelled ‘moderately high risk’, while a riskier sector-focussed fund is labelled ‘high risk’.

Fund houses do the risk classification of schemes based on their own assessment, though the risk labels are broadly similar across fund houses.

To check the risk label of any scheme, investors must look at the risk-o-meter (pictorial meter) on the monthly factsheet.

SEBI has now come out with an objective formula-based framework to gauge and disclose risks in mutual funds. The new risk framework comes into effect from January 1, 2021, for all existing as well as to-be-launched schemes.

What has changed

Under SEBI’s new framework, the risk level of each mutual fund scheme will be evaluated based on its actual portfolio composition, and will not simply depend on the category to which it belongs. The risk will be measured after taking into account multiple factors, each of which will be quantified to arrive at an overall score.

Debt securities in a scheme portfolio will be evaluated based on credit risk, interest-rate risk and liquidity risk. For equity holdings, the factors to be considered will be market cap, stock volatility and liquidity.

The final risk level will be a simple average of the scores on each parameter. The new framework also quantifies the risk associated with other securities such as cash, gold, REITs (real-estate investment trusts) held by MFs.

One more level of risk — ‘Very High’ — has been added to the existing five levels — Low, Moderately Low, Moderate, Moderately High and High — for depicting the risk associated with a mutual fund scheme.

The risk assessment will be undertakenon a monthly basis with any change in the risk label being communicated to investors. Fund houses will also have to disclose the number of times the risk label of a scheme changes in a year on their website and the AMFI (Association of Mutual Funds in India) website.

Implications for investors

With the new risk system, schemes within the same category may have different risk labels if their underlying portfolios differ from a risk perspective. This is not the case right now.

For instance, all liquid funds are currently labelled ‘low risk’. While this may be appropriate from an interest-rate risk angle, it may not always fully capture risk including credit and liquidity risk. Once the new labelling comes in, not all liquid funds may retain the ‘low risk’ tag.

In the equity space, mid-cap funds are currently categorised as ‘moderately high risk’ and must invest at least 65 per cent of their corpus in mid-cap stocks. Depending on where a mid-cap equity scheme invests the remaining 35 per cent of its corpus, its risk score under the new approach may be different from another fund in the same category.

Similarly, tactical calls involving shift of a large percentage of a fund’s corpus from large caps to small caps (in multi- cap funds, for instance) could also change the risk profile.

If the risk label of any mutual fund scheme that you have invested in changes in January 2021, you may want to re-evaluate your investments — possibly by moving into schemes that are in line with your risk appetite.

Keep in mind that while risk assessments must be updated every month, month-on-month changes in scheme risk labels need not necessarily happen.

“It is highly unlikely that fund managers will consciously alter the risk profile of a scheme frequently. One-off events such as credit downgrades for certain securities in a debt scheme portfolio may possibly have an impact,” says G Pradeepkumar, CEO, Union AMC.

However, investors should not rely solely on the risk label.

While two schemes with scores of 3 and 3.1 may not be very different from each other, the first will be labelled ‘moderate risk’ and the second ‘moderately high risk’.

Likewise, while any scheme with a risk score greater than 5 will be labelled ‘very high risk’, the extent of the risk may be quite different based on the actual risk score.

That being said, the risk labels can be a good starting point. As Mahendra Jajoo, CIO - Fixed Income, Mirae Asset Investment Managers India, points out, one constant feedback on debt funds is that they are far too complicated to understand. The new methodology is, therefore, a fair attempt to explain all the primary risk factors in one number, and represents a significant step forward, he adds.

For more clarity, investors can go through scheme portfolios in the monthly factsheets.

Regulating inter-scheme transfers

Inter-scheme transfers (ISTs) came under the spotlight after large-scale redemptions in credit-risk funds subsequent to the Franklin Templeton debt scheme wind-up. This highlighted the possibility of transfers of debt papers from these high-risk schemes to others schemes within the same fund house to generate liquidity to handle redemptions.

While SEBI does not provide scheme-level data on ISTs, aggregated data on ISTs in corporate bonds by mutual funds showed a spike in March and April 2020, pointing to the possible connection between increased ISTs with the liquidity pressures faced by credit-risk funds.

On the face of it, there is nothing wrong with ISTs, which essentially involve transferring of securities from one scheme to another within the same fund house. These are permitted under SEBI’s existing regulations provided the transfer happens at an arm’s length basis — such that neither the buying nor the selling scheme gets any undue benefit at the expense of the other.

The fear though is that schemes owning lower-credit-quality debt or illiquid stocks may take recourse to such a transfer to window-dress their portfolios or ready them to meet redemptions. So, while ISTs may help funds generate liquidity if any scheme faces large-scale redemptions, the transfer also needs to be fair to investors in the recipient scheme, by falling within its mandate and not unduly changing its risk profile.

The lack of data on scheme-wise ISTs for every fund house fuels concerns and speculations about their possible misuse.

SEBI’s tightening of rules for ISTs with effect from January 1, 2021, could serve as a check.

What has changed

The regulator has brought in several safeguards to ensure investor interest is protected, while allowing fund managers the flexibility to undertake ISTs in certain situations.

First, for close-ended schemes, ISTs will be allowed only within three business days of allotment following a new fund offer.

Second, for open-ended schemes, ISTs will be allowed where a scheme faces redemption pressures and the fund manager has already used up the scheme’s cash holdings, has attempted to sell the securities in the market, and has attempted to borrow from the market. Only then may the fund manager undertake ISTs and even then, only with relatively low-risk securities.

Fund managers have, however, been allowed some leeway on the use of market borrowing which may not always be feasible. ISTs will also be permitted if a scheme does the transfer to adhere to the regulatory limits on portfolio duration and on issuer-, sector- or group-related exposures.

Third, to ensure ISTs are not misused in credit-risk schemes (which anyway tend to have a high proportion of lower-rated, less liquid securities), performance incentives of fund managers and CIOs will be negatively impacted if the security becomes default grade within a year after an IST.

For other schemes, if a security gets downgraded within four months after an IST, the fund manager of the buying scheme has to provide detailed justification for the purchase, to the trustees.

Fourth, SEBI has debarred ISTs if there are negative news or rumours in mainstream media or if an alert is generated about the security based on internal credit- risk assessments.

Implications for investors

With SEBI’s stricter regulations, one hopes that the decision on ISTs will no longer depend solely on the judgement of fund manager/s of the schemes involved in the transfer.

The tighter norms should work towards removing the temptation to use ISTs as the measure of first resort.

The limited three-day window for ISTs in close-ended schemes can prevent the possible misuse of ISTs to transfer subpar securities into such schemes. This should safeguard the interest of investors in close-ended schemes which lack an exit option.

The regulations can also provide some assurance to investors in hybrid schemes (mix of equity and debt) against the possible misuse of ISTs. The debt portion in the portfolio of a hybrid scheme doesn’t always get as much investor attention as a pure debt scheme.

The equity portion, too, can provide some buffer against underperformance in debt. Transfer of securities (not all of which may be low-risk, high-credit quality) into these schemes to deal with liquidity issues in debt schemes can be a tempting option.

The stricter norms can also serve as a check on the temptation to use ISTs to prop up the performance of the more popular and widely tracked schemes at the expense of the smaller, lesser-known schemes. All these can protect investors from the possibility of getting short-changed in certain schemes.

Fund houses, on the other hand, will have to be better- prepared. According to Mirae’s Jajoo, it will be important for funds, particularly the larger ones, to have a better risk-management framework in place.

SEBI has asked fund houses to rename their dividend schemes from April 202 in order to provide greater transparency to investors.

‘Dividend Payout’ will become ‘Payout of Income Distribution cum capital withdrawal option’; ‘Dividend Re-investment’ will become ‘Reinvestment of Income Distribution cum capital withdrawal option’; and ‘Dividend Transfer Plan’ will be ‘Transfer of Income Distribution cum capital withdrawal plan’.

What has changed

There is no change in the way dividends will be calculated or paid out. What has changed is that fund houses will have to inform investors about the source of those dividends — how much of it is by way of income distribution and how much is simply capital distribution.

Implications for investors

Many investors see dividends distributed by mutual fund schemes as similar to dividends they receive from shares in listed companies. But they are not the same. Stock dividends are distributed from a company’s profits and represent a return on your investment. MF dividends, by contrast, are extracted from the fund corpus itself by selling off investments. The dividend payment may, in fact, also include some of your invested capital, which is being returned to you.

Therefore, when you pay tax on dividends received, not only do you pay tax on the income distribution component (which is capital appreciation) but also on the capital distribution component, which is part of the capital you originally invested. The new norms should help bring this out clearly to investors.

The new norms should help make this more clearly to investors.

In conclusion, all these recent changes will make mutual funds more sahi for investors.

Regulation of ISTs along with monthly risk evaluation of mutual funds based on their actual portfolio composition go hand in hand. Significantly sized ISTs involving illiquid, low-credit securities may no longer be able to circumvent the portfolio-based risk assessment, and could possibly get reflected in the form of higher risk scores for the impacted schemes.

Furthermore, experts suggest that providing publicly available data (for example, on the SEBI or AMFI websites) on ISTs at the scheme level for every fund house could go a long way in bringing in greater transparency for investors. Currently, SEBI provides data on ISTs in corporate bonds by all mutual funds put together.

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