Mutual funds are subject to corporate governance risk!!!

“Mutual fund investments are subject to market risk….” we all hear, read and see this time & again which is statutory requirement for mutual funds as per SEBI guidelines.(SEBI has reviewed advertisement guidelines for mutual funds in India) Apart from above disclaimer for investors one more disclaimer should be there stating that AMCs managing mutual funds are also subject to corporate governance risk! Because against the popular belief that mutual funds act and behave in the best interest of their investors, (by acting on clearly pre-defined investment objective and policy) quite often mutual funds behave with vested interest. In this blog, I am focusing on mutual funds that play foul on followings fronts; 

1. Not voting against the management of the investee companies

2. More than cozy relationship between mutual funds & companies

3. Unequal treatment towards various types of investors by mutual funds

1. Not voting against the management of the investee companies:

Current Scenario: Shareholder activism is very fancy word for the country like India and rarely practiced in India even by so called big institutional investors. As per SEBI guidelines,every AMC has to disclose their voting records to investors. Since first set of SEBI guidelines came in 2010 not much has happened on this front. Special Report on Mutual Fund Voting Pattern 2013 Analysis by ingovern (corporate governance research & vote advisory firm) shared some interesting facts like only 1.5 % of total resolutions put forth in 2012-13 were voted against by mutual funds. Back to year 2016-17, as per this article scenario remains more or less disheartening. Indian mutual funds giants like ICICI Prudential mutual fund, HDFC mutual fund, Birla Sunlife Mutual fund, Reliance mutual fund etc. also has dismal number to show.

Drivers behind current scenario:

1. Conflict of interest: If you observe, giant mutual fund houses in India have sponsor & trustees as banks or financial institutions. Certainly mutual funds would not like to take substantial business risk by voting against the management decision of the companies in which it has bought equity shares, as these companies might be bringing business in terms of borrowing from sponsor bank or investing surplus capital with sponsor bank or with other schemes of same mutual fund or bringing advisory, broking, fee- based work etc. kind of businesses to the parent company.

Example: Case of Maruti Suzuki’s related party transaction vote was quite contentious for the inventors. Let’s say XYZ mutual fund (which has sponsor as bank) has bought equity shares of Maruti Suzuki. Now in this case voting against the management may trigger unwillingness of Maruti Suzuki for future borrowing from the bank also if Maruti Suzuki has invested its’ surplus money with same XYZ mutual fund’s liquid scheme it may also loose a business & if in future Maruti Suzuki may come up for any financial activity plan like bond issuance, M&A, FPO etc. it may not prefer to give some part to this bank or related entity. On a similar line you can think of voting on Vedanta-Cairn merger issue, removal of Cyrus Mistry from board of Tata group of companies and so on.

Interesting to observe, foreign mutual fund houses like Franklin Templeton Mutual Fund etc. which do not have any other business in India besides running mutual fund has been quite vocal about taking stance against management decision by voting against them many times.

2. Further tightening of SEBI Regulation:  Currently SEBI guidelines allow mutual fund to abstain from vote on any management decision in the investee company. Many mutual funds are taking unfair advantage of this by abstaining from the vote instead of voting in favor or against, so they stay clear of any controversy or question from unit holders (actual investors in mutual fund).

2. More than cozy relationship between mutual funds & companies:

Current Scenario: Unfortunately many cozy (read favorable) relationships between mutual funds & investee companies are nicely swept under the carpet in such a way that many times not only small retail investors in such mutual funds but also regulatory bodies are also unable to smell it. Many mutual funds’ various debt schemes indulge in such “mutually beneficial” relationship where mutual funds lend via different routes & forms to highly risky companies. Case like Amtek auto and others points towards mutual funds’ deliberate inactions at initial stage. Many times behind the curtains the nexus of promoters, operators (brokers) and mutual funds with vested interest is the only (but very strong!) reason for buying shares of some really spurious companies. I have sensed many of these, based on my professional work experience in Indian financial markets. The investors who are completely unaware and face huge but hidden risk out of these kinds of mal-practices, are investors like you & me (the retail investors).

Drivers behind current scenario:

1. Lack of stronger disclosure norms for mutual funds: Since the inception of mutual funds in India till date, SEBI has done commendable job of tightening the norms & regulations of mutual funds. But history suggests that as the norms increase, the ingenious ways of flouting such norms has also increased. More stringent disclosure norms with more frequent time interval disclosure can give tough time to ethically weak fund managers.

2. Lack of knowledge & interest from unit holders: For any mutual fund, their unit holders are primary clients. These unit holders are many times incognizant of basic rights that they have. Also knowledgeable investors don’t demand the important information from the mutual funds they are invested into. This kind of unquestioning & trusting attitude from retail investors (and many times by bigger investors also) leads to many ethically and sometime legally questionable practices by mutual funds.

3. Unequal treatment towards various types of investors by mutual funds:

Current Scenario: This third dimension is most unknown to many retail investors. Many mutual funds unethically put the interest of one class of clients above another class of clients. For example for equity & debt funds cut off time to get same day NAV (Net Asset Value) for the investment is 3:00PM. If you as an investor applies before 3:00PM on any given day & money is deposited/transferred in mutual fund account before cut-off your investment is made at the close NAV of that day but if your transaction happen after 3:00PM then your investment will be considered on next day’s NAV & not on same day NAV. Here bending of the rules happens in favor of bigger clients (like corporates , institutional investors etc.) I have eye-witnessed, in many schemes (especially in liquid schemes) it happens mostly that even if big clients place buying application after the cut-off time, they are given favorable NAV rather than next day’s NAV which is applicable. Favorable clients (read bigger clients) are given chance for ‘Late trading’. Similarly, at the time of redemption of investment from mutual fund favorable treatment to bigger clients is given especially in case of unusual circumstances. The rumor did rounds at the time of rating downgrade of Amtek auto, that specific mutual fund allowed some set of institutional investors to redeem their investment before officially imposing redemption limit to all the investors in those schemes.

Drivers behind current scenario: Retail investor is the biggest victim in this as by no means he can come to know about favorable treatment given by mutual funds to bigger clients.

1. Lack of strong penalty & disclosure norms: Imposing strong penalty to those who are directly responsible (many times fund managers do not know but relationship managers & sales teams in order to get corporate business silently do this) & also penalty to the mutual fund should come into force.

It is high time that regulator be more proactive rather than reactive to many mal-practices prevailing in the mutual fund industry. This paper brings interesting insight as to how corporate governance at mutual fund might need different treatment than other corporate bodies. Retail investors can no longer live under the mercy of regulator. Being more vigilant & knowledgeable with the dose of client activism is what needed for Indian retail investors to remove the tag of ‘victim’!