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SEBI Gets Mutual Funds To Pull Their Socks Up


SEBI has changed the rules for mutual funds again, in support of the small investors.

First, for New Fund Offers (NFOs): They will only be open for 15 days. (ELSS funds though will continue to stay open for upto 90 days) It will save investors from a prolonged NFO period of being harangued by advisors, advertisements and flyers, nothing else; but the motivation behind the rule seems to be simple – if you can invest anytime, why keep a long NFO period?

Another rule is that NFOs can only be invested at the close of the NFO period. Mutual funds would keep an NFO open for 30 days, and the minute they received their first cheque, the money would be directly invested in the market; but that creates skewed accounting for those that entered later since they get a fixed NFO price. That is now solved.

To ensure that there’s no problem with interest, the ASBA process (Application Supported by Blocked Amount) is now applicable to Mutual Fund NFOs, meaning you continue to earn interest in your bank account until the NFO closes (remember there is usually no rejection or “oversubscription” in a mutual fund NFO)

These above rules apply for NFOs after July 01, 2010.

Mutual Funds have been known to push dividends as a source of attracting more investors; remember the Birla Sunlife ELSS scandal, where the Tax Relief fund was pushed to investors saying that a 1000% dividend, or Rs. 100, would be paid out of the fund in four months. The NAV of the fund was Rs. 200, and would drop to Rs. 100 – meaning the fund would pay out half it’s assets as dividend. But Birla Sun Life only had Rs. 59 cr. in assets before this dividend offer, a distributable surplus of around Rs. 30 cr. After the offer, and BEFORE the dividend was to be paid, investors piled on and assets went to over 200 crores – meaning they now had to pay our Rs. 100 crores as dividend! How can a scheme having only 30 crore surplus distribute Rs. 100 crore as dividend? Simple. Take the extra money from the new fellows coming in – who paid over 140 cr. to get in – , and give it right back as dividend. This is useful for investors in a tax saving scheme where your money is locked for three years; you get a tax benefit on the whole investment, and half your money back. Still, wherever new investors are being paid back out of their own money it dilutes the meaning of “dividend”, and the above practice is generally frowned upon. (For instance, companies can only declared dividends from realized profits, not from IPO money stored)

SEBI has put a stop to this. Dividends can now only be paid out of actually realized gains. Impact: it will reduce both the quantum of dividends announced, and the measures used by MFs to garner investor money using the dividend as a carrot.

An important distinction has been made in certain conditions where mutual funds are sold at less than face value (usually Rs. 10).

When units of an open-ended scheme are sold, and sale price is less than
face value of the unit, the difference between the sale price and face
value shall be debited to distributable reserves and the dividend can be
declared only when distributable reserves become positive after
adjusting the amount debited to reserves as per para 2(a) (ix) of Eleventh
Schedule of SEBI (Mutual Funds) Regulations.

To cut a long story short: This means if you are looking for dividend, don’t invest in funds that are trading at less than Rs. 10 – the above law screws things up for them. Applies to debt funds and MIPs also.

Equity Mutual funds have been asked to play a more active role in corporate governance of the companies they invest in. Not just that, they must reveal, in their annual reports from next year, what they did in each “vote” they were required to exercise in governance matters like management compensation, appointment of directors and change in capital structure. This will help mutual funds become more active but it is unlikely to change the course of action – Indian companies are largely promoter controlled and if there is a problem, Mutual Fund managers can be, er, appropriately compensated to vote in their favour. (I make no accusations. It happens, and it’s happening.)

Equity Funds were allowed to charge 1% more as management fees if the funds were “no-load”; but since SEBI has banned entry loads, this extra 1% has also been removed. All the recent NFOs intended to benefit from the earlier rule, and the clarification busts their chops.

SEBI has also asked Mutual Funds to reveal all commission paid to it’s sponsor or associate companies, employees and their relatives. 

Finally, SEBI has banned revenue-sharing agreements by Fund of Funds investing abroad. Some FoFs would invest in other funds abroad – like a “World Gold fund” which would invest in Gold Mutual funds in the UK – and ask those funds to kick back a part of the profits or commissions to the Indian AMC. That practice goes out the door.


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