SEBIís attempts to discipline Mutual funds - Views on News from Equitymaster

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SEBIís attempts to discipline Mutual funds

Oct 10, 2000

Securities and Exchange Board of India (SEBI) has proposed that mutual funds maintain records in support of each investment decision they take. This proposal has come in after SEBI found that the assets of many funds have depleted substantially and that some companies have not paid dividends or interest especially in the case of securities bought on private placement basis. The move if implemented would be commendable and could change the way mutual funds have been operating in India. Mutual funds have often accused companies in which they invest of not being transparent enough and of poor information flow. However when it comes to putting their house in order they have not been fair in their behavior too. Funds require information on companies to properly evaluate them before investment but are unwilling to share information about the fund to investors. Although objectives are stated in the prospectus very clearly, mutual funds never make or even properly record the rationale for any particular investment, thereby making it difficult to judge whether the objectives are being followed.

Thanks to the technology boom most of the funds had performed well in the past two years resulting in increased inflows of funds. The increased inflow meant quicker investments to be made. In the process of making quick investments many mutual funds had ignored the fundamentals of investment and invested in stocks that did not meet the criteria for sound investments. Mutual funds had research analysts but no clear method or database to justify why it invested in a particular stock. Since it was not compulsory to maintain such databases mutual funds found to easier to invest in obscure stocks (sometimes to bail out some broker) that did well in an overheated market but would hardly find any takers if the market were to slow down (this in fact is the case currently with many mutual funds stuck with unworthy or even illiquid stocks).

SEBI steps in
In order to protect investors from such poor investments SEBI has proposed that mutual funds record the rationale behind the investment decisions. Not surprisingly it has been met with protests from mutual funds courting practical difficulties in implementing the SEBI rules. The funds have questioned SEBIís decision on the grounds that this may imply that every trade transaction would have to be recorded and this could be tedious. This is really an untenable argument as investments made by professional managers are supposed to be based on research and sound logic. If in truth equity or fixed income research is being done then there is no reason why they should object to recording the rationale behind the investment decision.

While recording investment decisions may not immediately result in superior performance, it will at least help in pinpointing mistakes and also help in avoiding investments, which are not of sound nature. For some unscrupulous managers this could mean lesser chance to speculate and also mean lesser scope to accommodate any broker. Lack of proper recording of investment decisions also enables the fund manager to indulge in high amount of trading. A recent study done by a leading news agency points out that if one takes into account such aspects as UTI rarely trading in stocks that are its top holdings then the trading levels of other mutual funds can be nearly 1.5x to 2x the total amount invested in equity schemes. This high level of trading results in high transactions costs and lower returns to investors.

To conclude SEBI should insist that mutual funds keep a record of their investment decisions and also ensure that mutual funds report transaction costs and the portfolio turnover. This will in the long run facilitate a healthy growth of the mutual fund industry and ensure that the hard earned money of investors is not frittered away. Investors should be advised to invest or encourage only those mutual funds that give adequate information and follow the rules stipulated by SEBI. If SEBI does not take steps to protect the investors and nurture the growth of mutual funds there is bound to be a powerful backlash from investors who have been ravaged by the capital markets.

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