The Securities and Exchange Board of India made several good moves at its board meeting last week (their press release is here). The huge move towards transparency has been widely welcomed in the mainstream media and in the blogosphere.
I will therefore focus on the change that they have made to prohibit early exit from closed end mutual funds. This change appears to be directed towards Fixed Maturity Plans (debt funds) which were designed to eliminate interest rate risk for investors by investing in paper with the same maturity as the tenor of the scheme. The intention was to lock in the rate of return at inception and avoid any price risk at maturity. There could be a small reinvestment risk because of reinvestment of intermediate coupons, but this was negligible given the short maturity of most of these schemes.
This investor expectation about a predictable return has been rudely shaken because of large redemptions by big corporate investors during the liquidity crisis of October 2008. The mutual funds had to sell some investments at a loss and more importantly the residual portfolio quality also suffered because the best and most liquid investments were sold. The RBI’s scheme to lend to mutual funds does not solve this problem because the valuation of some assets is suspect and the liquidity window actually helps redeeming investors exit at an unrealistically high valuation.
SEBI’s move to simply prohibit premature exit restores the closed end debt scheme to its original function and design. With this in place, the RBI scheme for lending to mutual funds can be scrapped and can hopefully be replaced by a scheme to lend against units of mutual funds. This would provide liquidity to corporate investors who now face an unanticipated liquidity need. Evidently, liquidity is a privilege for which they should expect to pay a fair market price.
The SEBI press release also says that these Fixed Maturity Plans should not invest in paper with maturity beyond the tenor of the scheme. This too is necessary to ensure that these plan work as advertised. However, the language used refers to all closed ended schemes and would therefore appear to preclude a closed end equity fund since by definition an equity share is perpetual in nature. Hopefully, this will be fixed in the actual regulations.
I also think that SEBI needs to put in place a regulatory provision for suspending redemptions even from open end funds in extreme cases where it is impossible to determine the net asset value (NAV) of the fund reliably. The ongoing financial crisis continues to worsen. Earlier people like me worried mainly about defaults by real estate companies and NBFCs. Now the fear extends to the corporate sector as well with at least three of India’s largest business groups being perceived to be at risk of severe financial distress.
We still hope this distress will stop short of default, but a situation could arise where uncertainties about the financial situation of systemically important borrowers could lead to a situation where the NAV of mutual funds cannot be reliably determined.
As far as I am aware, there is no explicit requirement in the mutual fund regulations prohibiting redemption of units above net asset value or prohibiting redemption if the NAV cannot be reliably ascertained. (I think this is because the regulations were designed largely to protect the investors from the fund and not to protect the investors from each other.) I do not know whether a prohibition against such unfair redemptions (fraudulent preference?) can be inferred from general trust law. In any case, for complete clarity, it would be useful to write these into the regulations.
There is enough international experience in dealing with the impact of systemic defaults on mutual fund redemptions. I think Korea handled the DTC crisis after the Daewoo bankruptcy in an admirable way and there are lessons from there both for SEBI and for RBI. There are useful lessons from the Lehman bankruptcy in the US as well. Regulators should study these lessons and stand ready to apply them if such unfortunate situations arise in India.