10%RULE FOR MF]
5 Sebi rules that limit risks in MF schemes
Market risks are omnipresent in an MF, but strong regulations keep your fund manager in check
Statutory warnings, such as the one that mutual funds (MF) issue (“mutual fund investments are subject to market risk, please read the offer document carefully”) get monotonous. After a while they stop registering and you move right now without paying much heed to them. But risk is the middle name of any MF scheme; you can neither avoid it, nor ignore it and it helps to know that beyond these words there is a strong regulatory grid.
The capital market regulator, the Securities and Exchange Board of India (Sebi), has over the years strengthened the MF regulations to ensure that your risks get limited. Market risks are omnipresent in an MF, but strong regulations keep your fund manager in check. Here are five such rules.
Diversification through the 10% rule
It’s essential that your fund diversifies across scrips so that one unusual fall in a single scrip doesn’t take your entire fund down. Sebi rules say that your MF scheme cannot invest more than 10% in a single scrip. Sectoral schemes and index funds are, however, exempted from this rule. Since sectoral schemes invest in a single sector, like an information technology fund, there are limited scrips to choose from.
Rajeev Thakkar, chief executive officer, Parag Parikh Financial Advisory Services, says: “This makes sense for diversified funds. And 10% limitation isn’t bad at all. Even if a scheme has invested 9% each in about 12-13 scrips, it still becomes a very concentrated portfolio.”
Dhirendra Kumar, chief executive officer, Value Research, an MF tracking firm, reminds quickly that despite the 10% restriction, fund houses enjoy flexibility. “Debt funds can invest up to 100% in government securities because they come with the government’s backing,” says Kumar, adding that though fund houses cannot invest more than 10% in a single scrip, this rule is only to be implemented at the time of investments. If the value of the scrips rises later, MFs are not obliged to sell them.
Diversification through the minimum number of investors rule
Just like you need to diversify your holdings, your MF scheme must also diversify its investor base. As per Sebi rules, every MF scheme is supposed to have at least 20 investors and no single investor is supposed to invest above 25% of the scheme’s corpus. This is to ensure that no single investor holds a large chunk of your scheme. Reason being, when such an investor withdraws, your fund may need to sell the shares or debt securities of its most liquid companies to meet this large redemption. Those who continue to stay invested would then be left with lemons.
Every MF scheme is supposed to check the daily holdings of investors, who own at least 25% of the scheme’s corpus. At the end of every quarter, it takes a daily average of such large holdings to check if any investor has breached the 25% limit on a quarterly basis. The MF—and thereby the large investor—then gets a month’s time to rebalance the portfolio. If s/he fails to take any action, the fund house then gives such investors a 15-day notice period to redeem his excess holdings (above 25% of the scheme’s corpus), failing which the excess holdings get automatically redeemed.
These days fund houses are more proactive; they try and ensure that they don’t accept large amounts. “Large investors are sensitized and the marketing and sales teams are always on the alert. They usually alert large investors when they feel the limit could be breached,” says R. Sivakumar, head (fixed income and products), Axis Asset Management Co. Ltd.
In whose trust your money lies
One of the reasons why investors got lured by—and lost money in—the plantation scam between 1996 and 2002 (and for many more years after that in few other similar schemes) was that investors gave cheques directly to the plantation schemes.
However, when you write a cheque to a mutual fund, you write it in the name of the scheme that is a part of—and where your money goes to is—a trust. This trust is governed under the Indian Trusts Act, 1882 and is guarded by the trustees. The people who manage this money on your behalf are fund managers, who work in a separate company called the asset management company (AMC), which is governed by the Indian Companies Act, 1956.
The trustees have a fiduciary responsibility to ensure that your money is managed in the right manner. “While the AMC looks after the business side of the mutual fund, the trustees look after compliance and whether or not the AMC follows regulations when managing investor’s money,” says Shariq Contractor, partner, Contractor, Nayak & Kishnadwala Chartered Accountants and a trustee at BNP Paribas Trustee India Pvt. Ltd, the trustee company of BNP Paribas Asset Management India Ltd. Contractor claims that fund houses must be in regular touch with their trustees to ensure compliance, especially if it needs to deal with tricky issues. During the 2008 credit crisis that affected markets the world over, including India, when investors made a rush for panic redemptions, most fund houses had to take a call on whether they should make a distress sale of their underlying securities (selling securities at throwaway prices and incurring losses that is mostly passed on to the investors) to meet redemptions or to borrow money. Contractor claims that that was a tricky decision when the fund houses had to go back to their trustees to take their opinion. “When we take a decision, it goes right to the top management sitting outside India,” says Contractor.
Good broker, bad broker
Every time your MF buys or sells securities, its broker—who facilitates this transaction—earns a commission. To ensure that your broker doesn’t unfairly earn commissions on your behalf, Sebi has specified that your MF should not buy or sell more than 5% of the aggregate purchases and sales by the mutual fund through any single broker. The 5% limit is for any block of three months. If the MF breaches this limit, it needs to justify to its trustees why the limit was breached. However, your fund house cannot breach this limit if the broker is a sister firm and/or associated with the fund house or its sponsor. In 2006, the Supreme Court upheld Sebi’s order against the erstwhile Shriram Mutual Fund in a case pertaining to the years 1998 and 1999, where Sebi found, through an investigation, that the MF had bought and sold shares through its affiliate brokers in 12 instances over six quarters. Sebi had imposed a penalty of Rs. 5 lakh for this violation. sponsor.
“This is a very serious violation and Sebi takes it very seriously,” says Jimmy Patel, chief executive officer, Quantum Asset Management Co. Ltd. Although Sebi hasn’t specified norms on mutual funds on how to empanel brokers, fund houses are required to make a list of its reasons and the due diligence they do for empanelling. Your trustees get to look at them and voice objections if they feel your fund house hasn’t done its due diligence, adequately.
Tough to do front-running
In June 2010, Sebi accused HDFC Asset Management Co. Ltd, one of India’s largest fund houses, of front-running. This is a corrupt practice that is frowned upon in the securities market. Front-running means that a trader of an entity, say a mutual fund, enters into a stock market and buys a large quantity of shares just a few moments before the mutual fund itself buys the same securities. When the fund house buys this stock, the price moves sharply typically because it buys in large quantities. The broker then sells his holdings thereby profiting from the sharp rise in prices. Front-running can also be done when the mutual fund sells its securities.
Similarly, insider trading is a practice, whereby a person knowingly buys or sells securities after being privy to information that is not publicly disclosed or in other words, inside information.
Sebi doesn’t like it and is known to take action when it catches fund houses doing that. In 2001, Sebi issued a detailed circular that specified the processes that your fund house as well all its employees should undertake whenever any employee buys or sells any security from the stock market. For instance, whenever an employee buys or sell any share, he has to first make a written application with the fund house’s compliance office. If the fund house holds the share in any of its schemes, then there is a “cooling-off period” of 15 days. In other words, the fund house should not have bought or sold that within 15 days prior to the application date. Once the employee buys or sells this stock, he must report to the compliance within seven days. Note that the compliance officer’s approval—if it comes—is valid only for 10 days. Also, Sebi has said that employees cannot profit within 60 calendar days from the date at which the employee buys.
Mint Money take
MFs are risky instruments and do not offer guaranteed returns. But once you make your allocation to traditional fixed-income instruments, it makes sense to gradually invest in MFs as they are one of the better regulated financial instruments and offer better tax-adjusted returns.
5 Sebi rules that limit risks in MF schemes
Market risks are omnipresent in an MF, but strong regulations keep your fund manager in check
Statutory warnings, such as the one that mutual funds (MF) issue (“mutual fund investments are subject to market risk, please read the offer document carefully”) get monotonous. After a while they stop registering and you move right now without paying much heed to them. But risk is the middle name of any MF scheme; you can neither avoid it, nor ignore it and it helps to know that beyond these words there is a strong regulatory grid.
The capital market regulator, the Securities and Exchange Board of India (Sebi), has over the years strengthened the MF regulations to ensure that your risks get limited. Market risks are omnipresent in an MF, but strong regulations keep your fund manager in check. Here are five such rules.
Diversification through the 10% rule
It’s essential that your fund diversifies across scrips so that one unusual fall in a single scrip doesn’t take your entire fund down. Sebi rules say that your MF scheme cannot invest more than 10% in a single scrip. Sectoral schemes and index funds are, however, exempted from this rule. Since sectoral schemes invest in a single sector, like an information technology fund, there are limited scrips to choose from.
Rajeev Thakkar, chief executive officer, Parag Parikh Financial Advisory Services, says: “This makes sense for diversified funds. And 10% limitation isn’t bad at all. Even if a scheme has invested 9% each in about 12-13 scrips, it still becomes a very concentrated portfolio.”
Dhirendra Kumar, chief executive officer, Value Research, an MF tracking firm, reminds quickly that despite the 10% restriction, fund houses enjoy flexibility. “Debt funds can invest up to 100% in government securities because they come with the government’s backing,” says Kumar, adding that though fund houses cannot invest more than 10% in a single scrip, this rule is only to be implemented at the time of investments. If the value of the scrips rises later, MFs are not obliged to sell them.
Diversification through the minimum number of investors rule
Just like you need to diversify your holdings, your MF scheme must also diversify its investor base. As per Sebi rules, every MF scheme is supposed to have at least 20 investors and no single investor is supposed to invest above 25% of the scheme’s corpus. This is to ensure that no single investor holds a large chunk of your scheme. Reason being, when such an investor withdraws, your fund may need to sell the shares or debt securities of its most liquid companies to meet this large redemption. Those who continue to stay invested would then be left with lemons.
Every MF scheme is supposed to check the daily holdings of investors, who own at least 25% of the scheme’s corpus. At the end of every quarter, it takes a daily average of such large holdings to check if any investor has breached the 25% limit on a quarterly basis. The MF—and thereby the large investor—then gets a month’s time to rebalance the portfolio. If s/he fails to take any action, the fund house then gives such investors a 15-day notice period to redeem his excess holdings (above 25% of the scheme’s corpus), failing which the excess holdings get automatically redeemed.
These days fund houses are more proactive; they try and ensure that they don’t accept large amounts. “Large investors are sensitized and the marketing and sales teams are always on the alert. They usually alert large investors when they feel the limit could be breached,” says R. Sivakumar, head (fixed income and products), Axis Asset Management Co. Ltd.
In whose trust your money lies
One of the reasons why investors got lured by—and lost money in—the plantation scam between 1996 and 2002 (and for many more years after that in few other similar schemes) was that investors gave cheques directly to the plantation schemes.
However, when you write a cheque to a mutual fund, you write it in the name of the scheme that is a part of—and where your money goes to is—a trust. This trust is governed under the Indian Trusts Act, 1882 and is guarded by the trustees. The people who manage this money on your behalf are fund managers, who work in a separate company called the asset management company (AMC), which is governed by the Indian Companies Act, 1956.
The trustees have a fiduciary responsibility to ensure that your money is managed in the right manner. “While the AMC looks after the business side of the mutual fund, the trustees look after compliance and whether or not the AMC follows regulations when managing investor’s money,” says Shariq Contractor, partner, Contractor, Nayak & Kishnadwala Chartered Accountants and a trustee at BNP Paribas Trustee India Pvt. Ltd, the trustee company of BNP Paribas Asset Management India Ltd. Contractor claims that fund houses must be in regular touch with their trustees to ensure compliance, especially if it needs to deal with tricky issues. During the 2008 credit crisis that affected markets the world over, including India, when investors made a rush for panic redemptions, most fund houses had to take a call on whether they should make a distress sale of their underlying securities (selling securities at throwaway prices and incurring losses that is mostly passed on to the investors) to meet redemptions or to borrow money. Contractor claims that that was a tricky decision when the fund houses had to go back to their trustees to take their opinion. “When we take a decision, it goes right to the top management sitting outside India,” says Contractor.
Good broker, bad broker
Every time your MF buys or sells securities, its broker—who facilitates this transaction—earns a commission. To ensure that your broker doesn’t unfairly earn commissions on your behalf, Sebi has specified that your MF should not buy or sell more than 5% of the aggregate purchases and sales by the mutual fund through any single broker. The 5% limit is for any block of three months. If the MF breaches this limit, it needs to justify to its trustees why the limit was breached. However, your fund house cannot breach this limit if the broker is a sister firm and/or associated with the fund house or its sponsor. In 2006, the Supreme Court upheld Sebi’s order against the erstwhile Shriram Mutual Fund in a case pertaining to the years 1998 and 1999, where Sebi found, through an investigation, that the MF had bought and sold shares through its affiliate brokers in 12 instances over six quarters. Sebi had imposed a penalty of Rs. 5 lakh for this violation. sponsor.
“This is a very serious violation and Sebi takes it very seriously,” says Jimmy Patel, chief executive officer, Quantum Asset Management Co. Ltd. Although Sebi hasn’t specified norms on mutual funds on how to empanel brokers, fund houses are required to make a list of its reasons and the due diligence they do for empanelling. Your trustees get to look at them and voice objections if they feel your fund house hasn’t done its due diligence, adequately.
Tough to do front-running
In June 2010, Sebi accused HDFC Asset Management Co. Ltd, one of India’s largest fund houses, of front-running. This is a corrupt practice that is frowned upon in the securities market. Front-running means that a trader of an entity, say a mutual fund, enters into a stock market and buys a large quantity of shares just a few moments before the mutual fund itself buys the same securities. When the fund house buys this stock, the price moves sharply typically because it buys in large quantities. The broker then sells his holdings thereby profiting from the sharp rise in prices. Front-running can also be done when the mutual fund sells its securities.
Similarly, insider trading is a practice, whereby a person knowingly buys or sells securities after being privy to information that is not publicly disclosed or in other words, inside information.
Sebi doesn’t like it and is known to take action when it catches fund houses doing that. In 2001, Sebi issued a detailed circular that specified the processes that your fund house as well all its employees should undertake whenever any employee buys or sells any security from the stock market. For instance, whenever an employee buys or sell any share, he has to first make a written application with the fund house’s compliance office. If the fund house holds the share in any of its schemes, then there is a “cooling-off period” of 15 days. In other words, the fund house should not have bought or sold that within 15 days prior to the application date. Once the employee buys or sells this stock, he must report to the compliance within seven days. Note that the compliance officer’s approval—if it comes—is valid only for 10 days. Also, Sebi has said that employees cannot profit within 60 calendar days from the date at which the employee buys.
Mint Money take
MFs are risky instruments and do not offer guaranteed returns. But once you make your allocation to traditional fixed-income instruments, it makes sense to gradually invest in MFs as they are one of the better regulated financial instruments and offer better tax-adjusted returns.
