These Rules Applicable to Mutual Funds Come Into Effect from January 2021

Jan 02, 2021

Last year, the news of Franklin Templeton MF abruptly shutting down six of its debt scheme shocked the mutual fund industry and its investors. This never-seen-before event shook the confidence that investors had in the mutual fund industry.

Since then market regulator, SEBI had announced a slew of measures to improve transparency in the way mutual funds operate and make fund houses more accountable for their actions, thereby protecting investors' interest.

Some of the measures were implemented during the year are:

With effect from January 1, 2021, the following rules come into affect:

1) New Risk-o-Meter guidelines

The regulator has repeatedly advised fund houses to stick to their labels and clearly convey the risks involved in a particular scheme as well as category. Keeping this in mind, in October 2020, SEBI revised the guidelines for product labelling of mutual fund schemes for all existing and upcoming schemes.

At present, mutual fund schemes are classified across five risk levels, namely -

Low risk, Moderately Low risk, Moderate risk, Moderately High risk, and High risk.

The capital market regulator has now introduced a new sixth level--Very High risk.

Moreover, the market regulator has directed mutual fund houses to carry out the exercise of risk labelling at the 'scheme level' contrary to the earlier practice of it being done at the scheme-category level. So, if all mutual funds classified their equity schemes in the 'high risk' category earlier, now the classification will differ from one scheme to another depending on their portfolio attributes.

The parameters for evaluation of risk will be different for equity and debt schemes. To know more about the risk evaluation parameters click here.

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2) Inter-scheme transfer norms tightened

SEBI has tightened the norms on inter-scheme transfer (IST) of bonds so that such transactions do not expose transferee schemes to unwarranted risks. According to SEBI, IST is allowed only if such transfers are done at the prevailing market price for quoted instruments on a spot basis and the securities therefore transferred are in conformity with the investment objective of the scheme to which such transfer has been made.

Further, it has prescribed the following additional safeguards:

1) Close-ended schemes will be allowed IST purchase only within three business days of allotment pursuant to New Fund Offer (NFO). No ISTs will be allowed to and from close-ended schemes thereafter.

2) Open-ended schemes will be permitted ISTs in the following scenarios:

  • During the event of unanticipated redemption pressure a fund can opt for IST only if there is still scheme level liquidity deficit after utilising the below measures:

    • Use of scheme cash & cash equivalent

    • Use of market borrowing

    • Selling of securities in the market

  • IST will be allowed for rebalancing to meet the regulatory limit relating to duration, issuer, sector and group, provided that balancing is required in both the transferor and transferee schemes. If the security of the credit schemes is assigned a default grade within one year of IST, the performance incentive of fund managers, chief investment officers, etc. involved in the process will be negatively impacted.

3) Dividend option renamed

Based on the recommendations of Mutual Funds Advisory Committee (MFAC), SEBI has asked mutual fund houses to rename the dividend option under:

Option / Plan Name
Dividend Payout Payout of Income Distribution cum capital withdrawal option
Dividend Re-investment Reinvestment of Income Distribution cum capital withdrawal option
Dividend Transfer Plan Transfer of Income Distribution cum capital withdrawal plan
 

SEBI stated the need to clearly communicate to the investor that under the dividend option of a Mutual Fund Scheme, certain portion of their capital (Equalization Reserve) can be distributed as dividend.

The regulator has directed all mutual funds to disclose the amount that can be distributed out of equalization reserve which represents realized gains in their offer documents.

Plus, fund houses shall disclose this information to investors at the time of investing in such options.

The regulator also wants mutual funds to maintain clear segregation between income distribution (appreciation on NAV) and Capital Distribution (Equalization Reserve) in the consolidated account statement provided to investors.

4) True to label multi cap funds

To ensure that multi cap funds hold a diversified portfolio across large, mid and small cap companies, be true to its label, and to distinguish it clearly from other scheme categories, SEBI has partially modified the characteristics of multi cap fund.

Multi-Cap funds will now have to invest at least 75% of its total assets in equities, with at least 25% exposure each in large cap, mid cap and small cap stocks as compared to earlier mandate of investing minimum 65% of its assets in equity and equity-related instruments with no limit on market cap allocation.

Fund managers who are apprehensive about reshuffling of the portfolio or merging with other schemes have the option to rebrand the multi cap scheme as a flexi cap fund, a new category under equity schemes that can dynamically allocate its assets across market capitalisation.

Framework for uniformity in applicability of NAV deferred

SEBI has extended the date for implementation of framework for uniformity in applicability of net asset value (NAV) in case of purchase of mutual fund units to February 1, 2021.

As per the new framework, investors in equity and debt funds will be allotted mutual fund units based on the closing NAV of the day on which the asset management company (AMC) receives the fund. This will be done irrespective of the size and time of receipt of such application.The cut-off time remains unchanged at 3 pm.

The deferment was done based on the request by Association of Mutual Fund in India (AMFI). According to AMFI, the request was made in light of certain circulars issued by the central bank, which have posed significant unexpected challenges and implications on the banking arrangements of mutual funds.

AMFI further added that the deferment will allow the industry adequate time to first migrate all banking arrangements before taking up the necessary changes in order to comply with the circular. It will also avoid potential disruption of services to investors.

More measures under consideration

Meanwhile, SEBI is mulling over more measures which are expected to be implemented over time in consultation with the mutual fund industry. Here are some of them:

  1. Mandatory 10% minimum exposure in liquid assets such as government securities, cash, treasury bills, and tri-party repo

  2. Gating of redemptions during extreme events to prevent any pressure on the fund

  3. Assess whether the side-pocket creation norms need to be revisited

  4. Stress testing for all open-ended debt oriented mutual fund schemes that will raise early warning signs and enable AMCs to take necessary actions

  5. Swing Pricing / Anti-dilution levy to pass on the cost of transaction to the transacting investor undertaking large redemption in time of crisis

  6. Facilitate repo in corporate bonds in order to increase liquidity in secondary markets and to enable greater issuances of paper rated below AAA

  7. Setting up of back-stop facility, i.e. an entity that would buyout illiquid corporate bonds from debt funds in times of stress

SEBI has over the last couple of years taken bold steps to transform the mutual fund industry and may continue to do so in the future as well. How mutual fund houses respond to these changes remains to be seen.

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Warm Regards,
Divya Grover
Research Analyst

 

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