On Thursday, the Securities and Exchange Board of India (Sebi) changed some of the basic rules under which mutual funds operate in this country. The rules are being tightened in response to the problems that mutual funds have faced due to the global financial crisis. If you are not familiar with the intricacies of how mutual funds operate, the changes can sound fairly technical. However, the new rules are important for all investors and will drastically affect some types of funds.
The most important change that has happened is that Sebi will not allow fund companies to offer early encashment in any closed-end fund. To understand the significance of this change, let’s recap the basics of open-end and closed-end funds. An open-end fund is one, which is continuously open in the entry and exit of investors. Investors can buy fresh units from the fund company at any time and can also encash their investments at any time by redeeming the units back to the fund company at any time. This sale and purchase is at the net asset value (NAV). Depending on the type of fund, there may be a load charge of up to 2% or so. Open-end funds are perpetual in nature-once launched, there is no fixed period after which they have to terminate.
Closed-end funds, on the other hand, have a definite start date and an end date. All investors can invest only in the beginning and can encash their investments only at the end.
At least that was the theory. In practice, India’s mutual fund rules demand that fund companies provide some way for investors to get out whenever they want to. Once upon a time, this was generally done by listing funds on the stock market. This way, investors could sell their units to other investors at any time without involving the fund company. Of course, trading volumes are always thin and since there were always more sellers than buyers, funds’ market prices were almost always at a discount to the actual NAV.
In recent times, fund companies had started providing the mandatory liquidity by offering direct redemption of closed-end funds instead of listing them. In effect, this meant that closed-end funds were only closed to entry, exit was open.
Now, Sebi has forbidden this ‘early redemption’ route. It has said that funds must offer premature encashment only through the listing route. However, low volumes and big discounts are unlikely to make listing a viable option. In effect, closed-end funds are now genuinely closed-end.
This change of rules is Sebi’s response to the recent liquidity crisis in Fixed Maturity Plans (FMPs). The crisis was caused entirely by funds offering premature encashment in funds whose underlying assets could not be sold prematurely except at a discounted price. The other big change that Sebi has made is similar in spirit-closed-end funds’ debt investments must be made only in those bonds whose maturity (redemption) date is no later than the funds’ own redemption date.
Taken together, the intent of these rule changes are clear-maturity mismatches must be eliminated all the way from the fund investor to the underlying investments because it were these mismatches that almost brought the industry to its knees during October and November. Interestingly, on both these points, Sebi’s regulations are far tougher than what the fund companies themselves had recommended through their lobbying body, AMFI (Association of Mutual Funds in India). The industries’ own recommendations were basically just some cosmetic changes that could not have prevented another liquidity crisis-Sebi’s new regulations would prevent such a crisis.
However, the new regulations may also lead to big drop in the FMP businesses. Without instant NAV-based liquidity and without the extra returns offered by holding long-maturity bonds, FMPs would be a lot less attractive to corporate investors.
The author is CEO, Value Research