A crackdown on lazy investing

Sucheta Dalal 02 Apr 2007

As liquidity gets tighter, interest rates are zipping upwards. Last week, leading private banks were offering 14% interest on 3-month fixed deposits of Rs 2 crore plus. A load of money is also rushing into Fixed Maturity Plans (FMP) of Mutual funds. The 13-month FMP offering with double indexation benefits indeed offer a smart way to earn double-digit returns on a post-tax basis. But it works best for investors who are able to cut through the media hype and pick the correct FMP scheme, since returns across schemes are not uniform, nor definite like those of taxable FDs.

If the parking of short-term funds is attractive for individual investors and cash-surplus companies, the regulator believes that it is significantly more attractive for mutual funds. A new fund offering (NFO) usually parks its collection in such liquid instruments until the money is invested in line with objectives of the scheme.

Although such short term deposits (STD) with commercial banks do not qualify as money market instruments, or, as a security under the relevant act, mutual funds are allowed to park money in such instruments "pending deployment of funds" according to objectives of specific schemes. However, rising interest rates are making STDs very attractive in a volatile and risky capital market scenario. Sebi believes that fund managers are loath to pull funds out of these safe deposits and are using them as a 'regular investment avenue' rather than short-term parking slots. This has some interesting consequences.

From the ordinary person's perspective, it is rather unfair, because the interest earned on direct investment in fixed deposits is taxable in the hands of the investor, but mutual funds get to invest in shorter-term deposits and interest received by the scheme is tax-free in the hands of investors.

Sebi apparently wants to plug this perceived loophole. In fact, data shows that five months after their new fund offering, barely three growth schemes had over 30% of their corpus in cash which would include STD. Does Sebi have a different set of numbers than are disclosed to the public? Possibly. The regulator has been in long discussions with the Association of Mutual Funds of India (Amfi) to stipulate guidelines for parking short-term funds. This, in itself, is a good thing, even if the numbers do not indicate such a worrying trend. Specifically, Sebi wants to restrict investment in such short-term deposits to 91 days and stipulate a set of rules to prevent incestuous relationships between banks and funds. It proposes to stipulate that only 15% of a scheme's corpus can be parked in short-term deposits (this can be enhanced to 20% with the permission of trustees) at any point of time.

In a rising fixed return scenario, regulations will prevent lazy investing by fund managers and mutual fund schemes

Another regulatory concern about mutual fund money going straight into short-term bank deposits is that it may create a dependency between mutual funds and specific banks. Hence, the regulator proposes to restrict investment through STD in any one bank or its subsidiaries to 10% of the net asset value; further, only 20% of the total investment in short-term deposits can go to a sponsor/associate bank. Trustees must also ensure that there is no reciprocal ties, where a bank invests in a mutual fund scheme and the scheme in turn, gives the money back to the bank as a STD.

Interestingly, Sebi proposes to mandate that funds parked in STDs of banks must be "invested in the name of the concerned scheme". It does not say if this is happening on a large-scale today. But if it is, this could be one reason why scheme specific data does not reflect a worryingly large investment in cash. However, it suggests a serious breach of fiduciary responsibility that Sebi proposes to plug through enhanced disclosure. It wants half-yearly reporting on STDs along with the name of the bank, quantum of funds invested and the percentage of NAV it represents.

The change in mutual fund regulations was part of the agenda for Sebi's board meeting a week ago, but it is not clear if the proposed amendments have been approved. In a rising fixed return scenario, these regulations will certainly prevent lazy and complacent investing by fund managers and mutual fund schemes, which earn fat fees and bonuses for their investment expertise.

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