8 Regulatory Changes SEBI Introduced to Protect Mutual Fund Investors…   Oct 22, 2016

In the aftermath of financial crisis of 2007-08, investors started losing interest in mutual funds. The market meltdown wasn't the sole reason for investors' apathy. Gross mis-selling that happened in the mutual fund industry in the pre-crisis era had caused novice investors to believe that mutual fund are the safest mode to earn high returns. Many of them had invested in mutual funds without knowing the risks associated with investing. Debt schemes offered by mutual funds remained largely restricted to institutional investors as investors chased equity oriented schemes. The Securities and Exchange Board of India (SEBI) recognised that, if such a situation persists for long, the mutual fund industry could lose credibility one day.

In India, many times pro-investor moves are unfortunately considered anti-industry. Which is why SEBI chief, Mr U.K. Sinha has clarified several times that the capital market regulator is not anti-distributor. Mr U.K. Sinha and his predecessor, Mr C.B. Bhave introduced many regulatory reforms to make the mutual fund industry more transparent and investor friendly.

Many SEBI initiatives helped curb misselling, improve processes, and tightened up regulations to protect investors' interest. Here are some of the most important ones

  1. The entry load ban – Prior to August 2009, it was a common practice for mutual funds to charge entry loads on investors. It was an amount deducted upfront from the invested corpus and paid to the distributors, since investors were reluctant to pay consultancy fees separately. However, taking undue advantage of this facility, mutual fund distributors encouraged investors to churn their portfolio unnecessarily. Investors who relied on the distributors' advice, ended up overestimating gains and undermining risk involved. The ban on entry load served as a deterrent to the distributors as there were little incentives when investors churned their portfolios.

  2. Introduction of Uniform factsheets – On numerous occasions, mutual funds have exposed investors to unwarranted risks. Consider the recent episodes of their investments in bonds of substandard credit quality and/or even the overexposure to a particular stock or a sector. To make investors better informed about the fundamental attributes of the scheme, SEBI directed mutual fund houses to standardise their fact sheets, about a year ago.

  3. Colour coding to risk-o-meter – In 2013, SEBI made it mandatory for the mutual fund houses to use product labels with colour codes to help investors assess the risk involved while investing in a respective mutual fund scheme. It made it obligatory on the part of mutual fund houses to disclose product labels carrying details of the scheme on the front page of initial offering application forms and asked them to be placed in common application forms and advertisements.

  4. The labels included details of the mutual fund scheme – Whether equity or debt – along with the objective i.e. "to create wealth or provide regular income" and imbibed a time horizon (short/ medium/ long term) indicatively the product labels exhibition of right colour codes for a respective mutual fund scheme was made compulsory. The colour Blue code indicated Low Risk, Yellow - Medium Risk, and Brown denoted Highest Risk. But later to help investors understand the risks better, SEBI introduced a concept of 'risk-o-meter' and made it applicable to all mutual fund houses with effect from July 01, 2015. The risk-o-meter allows you to classify risk into five levels such as: Low -> Moderately Low -> Moderate -> Moderately High -> High

  5. Introduction of SEBI RIAs – The commission driven nature of mutual fund distribution works, by and large, against the investors' interest. Moreover, as distributors receive compensation from the mutual funds, they push aside their responsibility and accountability towards novice investors. But now to correct this malpractice and crack the whip, the capital market regulator has enunciated requirements related to obtaining a certificate of registration, qualification, capital adequacy, period of validity of the certificate, and has also mentioned other general obligations and responsibilities on the part of investment advisors. With such a regulation coming into force, investors would finally be in safe hands, dealing with registered investment advisors and can expect improvement in the quality of advice due to them being made more accountable and responsible by the capital market regulator, since they have to abide by a certain code of conduct. Such a regulation in our view could protect investors, and could safeguard them in case if a legal battle erupts with their investment advisor. We also believe such a step would help build confidence in the minds of investors and make the investment advisory business in India more regulated and responsible.

  6. Insisted on merging alike schemes – There is a tendency among investors to get swayed by the past performance of markets. They make investment decisions based on the market trends. If the markets have fallen in the immediate past, they go bearish. On the other hand, they tend to ignore valuations and invest in equity oriented schemes offered by mutual funds if the market trend is strong. Mutual fund houses and greedy distributors take undue advantage of such predispositions investors have. They sell stories and increase their Assets Under Management (AUM). Mutual fund houses and their distributors do not want to answer difficult questions and take a tougher route that goes through a jungle. They want flat highways. They want to grow their AUMs without taking pains of educating investors adequately—something that PersonalFN always believes in. PersonalFN has taken many initiatives to educate investors.

    For all these reasons, lately, the capital market regulator has been nudging mutual funds to merge similar schemes. The regulator also wants them to cut down the number of NFOs they introduce in the market. It has been observed that investors get confused because of a vast number of similar offerings.

  7. Introduction of Direct Plans – When you invest in direct plans offered under various mutual fund schemes, you eliminate the services of a mutual distributor / agent / relationship manager. The transaction may be performed online or even physically by visiting the registrar's or the asset management company's office. The idea behind introducing the direct plans was to reduce the role of distributors in increasing the retail participation. If investors approach mutual funds directly to transact, the fund houses would be able to cut off the long chain of distributors and agents who have always added to their cost structure. In return, the mutual fund houses would pass on these cost savings to the investors in the form of a lower expense ratio. The expose ratio tells you how much as a percentage of the scheme's corpus the total expenditures are. This was considered to enhance the returns for the investors.

  8. Mandatory disclosure of commission (in the account statement) paid to distributors – As directed by SEBI, fund houses will now have to disclose the commissions they pay to distributors, in Rupee terms, for the businesses he/she solicited from you. However, recent developments suggest unlike directed earlier, mutual funds will have to divulge information about the expense ratio of a plan's scheme. Hitherto, SEBI has insisted that the fund houses would have to disclose the expense ratios of both—direct and regular plans.

    Despite this relief provided by SEBI, distributors are still concerned about the future of their business. They believe since it's the first time, their clients would know the exact amount of commission a distributor receives as against the mutual fund schemes pushed or advised, it could have a negative impact on their business.

PersonalFN is of the view that, unless mutual fund houses change their commission oriented business models and stop taking the NFO route to growing their AUM, they are likely to struggle. This is evident from the fact that many fund houses have exited from India operations in the recent past. Investor education is the only way out and thus fund houses should devote more time and resources to creating awareness among investors.

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