Mutual funds shooting themselves in the foot?
The investor runs the risk of losing his capital if investments by the fund manager turn sour.
There would be a run not just on the bank that does something like that, but probably a host of banks would witness a rub-off effect. Can something similar happen to mutual funds? Not yet.
Investors still believe that what they see as net asset value of their investments every morning would be handed out to them when they need it.
But that faith may not last very long if mutual fund managers do not keep their promises. The decision of the two large mutual funds to carve out the holdings in a defaulting firm without exercising their rights raises the question whether they are doing justice to their investors.
Mutual fund as a concept is a passthrough institution. An investor in a scheme gets the market value of his holding irrespective of profits or losses. The investor runs the risk of losing his capital if investments by the fund manager turn sour.
Unlike deposits where the risk is borne by the bank, in mutual funds the investor bears the risk. Simply, it is a case of heads I win and tails you lose for Asset Management Companies.
What went wrong? These funds invested in the bonds sold by Zee Group promoter Subhash Chandra’s companies which defaulted on interest payments. Funds had the shares of various group firms as collateral with covenant that at any point it should be 1.5 times the borrowing.
When there is a default and the value of collateral breaches the stipulated limit, either the lender gets more collateral or sells out the collateral to recover what is owed to it so that it repay its investors.
“Majority of lenders, reached a conclusion that, if all the lenders were to invoke pledge of shares and liquidate the security, it would have resulted in erosion of collateral value and led to sub-optimal recovery of dues,’’ Kotak said in a note to investors.
In this case, mutual funds were worried about the value erosion for the borrower if they sold off the collateral instead of repaying their investors who entrusted them with their savings. It was a case of misplaced loyalty.
Debate about funding promoters is more digression than meaningful. If Chandra was facing temporary problems there were other routes like funding by non-banking finance companies to keep him going rather than compromising mutual fund investor interests.
Investors can take market risk, but not mismanagement risk.
The regulator may have played a role in this misbehaviour by mutual funds.
Its hurried introduction of the ‘side-pocketing’ scheme post the Infrastructure Leasing & Financial Services blow-up last year has emboldened mutual funds. What was a one-time bail out for the US-64 scheme that sank the Unit Trust of India was introduced for the entire industry.
Side pocketing is a concept where mutual funds can keep aside the securities of a defaulter and repay the investor after realising its actual value. That safety net intended at stability has the potential to encourage adventurism, than conservatism.
Mutual funds is a good business to be in where the profitability is quite high once grown to a certain size. AMCs that run them have no skin in the game unlike banks where the shareholder is on the hook for bad loans. All that one requires to start a mutual fund is Rs 50 crore irrespective of the asset size whereas banks have capital adequacy in proportion to their loans.
Revenues of top 39 mutual funds which have assets of Rs 21 lakh crore rose to Rs 12,984 crore in fiscal 2018, from Rs 3,579 crores in 2011. Their profit before tax margin is at 35 per cent, up from 19 per cent during the period, data from the regulator shows. Bigger is better. For large AMCs, the profit margin is at 46 per cent.
The regulator in the past had penalised the likes of JPMorgan Mutual Fund for bad decisions to protect investors. But that has been given a good bye.
While the industry has grown at an average of more than 20 per cent since the turn of the century, the quest for size and tax proposals have made it riskier for small investors.
Treasuries of big companies dominate the fixed income side of mutual funds with them comprising half the debt schemes. In liquid and money market funds, retail is less than 5 per cent while corporates are at 70 per cent.
To make it better for less savvy investors, the regulator may prescribe capital in proportion to the size of the assets manage like it is for banks. Mandating a cap on corporate investments in schemes that have retail investors would ringfence the common man.
Without adjustments and making the mutual fund industry robust, they may well squander the benefits derived from demonetisation.
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