SEBI revises risk management framework for mutual funds

Mutual fund houses are having the time of their lives. Never before have there been this many retail investors in the mix. Moreover, retail investors might have limited knowledge about the intricacies of finance and the stock market and might not, therefore, be able to catch a mutual fund breaking the rules. Retail investors might practice due diligence and get educated on making informed choices, but they might not have the bandwidth to explore every investment made by a fund house and they may not have the expertise to judge when an asset management company is not acting in their best interests. They might also not be in a position to judge when a fund house is forgoing risk management for higher potential profitability, raising the risk profile beyond what investors may have bargained for.

Do not be alarmed. Nothing untoward or alarming has happened. At least not yet, and if all goes as planned, mutual fund houses will be on a far tighter leash going forward.

SEBI, the market regulator, the watchdog and the protector of investor interests and fair play, has stepped in to ensure that mutual fund houses toe the line. If you have been investing in stocks, bonds, F&O or mutual funds, you must be aware the Securities Exchange Bureau of India is to the capital markets what the BCCI is to Indian cricket.

To get a clear understanding of how SEBI is safeguarding investor interest, you must have a thorough understanding of risk management. Let's begin by understanding risk in mutual funds.

What is the risk associated with mutual fund investments

Honestly not a lot of investors "read the offer document carefully before investing" and as a result, some investors who put their money in SIPs, do not even understand that they are investing in mutual funds and therefore bear stock market exposure, and as a result, also bear stock market risk.

When you invest in a mutual fund, your capital is pooled with that of other investors and the fund manager named in the product literature - together with his or her team - pick investments in the stock market to grow your capital. They might choose stocks and bonds or might undertake hedging measures by using futures and options trading.

The mutual fund typically presents itself as very high risk, high risk, medium to high risk, medium risk, medium to low risk, low risk or low very risk. They are supposed to choose investments based on the risk profile that they claim to have.

Stocks are high risk and bonds are comparatively low risk. Futures and options are a complex game and the risk depends on what strategy you employ. Meanwhile, within stocks, large cap stocks are relatively low risk as compared to midcap and smallcap stocks. Government bonds are seen as less risky than corporate bonds. But the risk is also proportional to potential returns. And the returns that a fund house delivers is what keeps more investor capital coming in (although as an investor this isn't the smartest way of choosing mutual funds, that's a discussion for another day).

You get the idea: under pressure to deliver competitive returns and outdo one another, mutual fund houses might pick riskier investments than they are supposed to as per their published risk profile.

What has SEBI done to protect investors?

SEBI has issued a directive saying that all mutual fund houses need to establish a risk management framework. The RMF put into place by fund houses is aimed at guiding the processes and management at fund houses across strategy and daily operations.

Fund houses have until January next year to get an RMF in place. By January 1 in 2022, all of India's asset management companies must do two things 

1. Complete a self assessment of their ongoing risk management framework or moves or policies or processes or whatever they have going. You might compare this to an internal audit. 
2. Ensure accountability by appointing specific CXO level management executives for each pillar of an asset management company's risk management measures. For example, there should be a chief investment risk-management officer, another chief compliance risk-management officer, a chief IT security risk-management officer, a chief operational risk-management officer and so on. 
3. Prepare a roadmap for a watertight risk management framework that will not need SEBI to pull them up.

Two fund houses have indeed recently been pulled up and taken to task. This might be sufficient warning and incentive for the other asset management companies in the mix to pull their socks up and buffer their risk management commitment, measures, compliance and adherence.

Why did SEBI revise the risk management framework for mutual funds?

For two reasons: SEBI caught Kotak Mahindra Asset Management and Franklin Templeton - two big names in the business - breaking the rules. The former was barred from putting out any fixed income schemes and the latter from launching any debt schemes (which are linked to bonds and therefore might also lean towards fixed income).

The mutual funds advisory committee reviewed the status quo based on sector level recommendations and calls for change.

What this means for investors

While we cannot be sure of how SEBI's measures will affect mutual fund houses and the investor capital already in their hands, and future investments, one might expect

• Higher expense ratios

With all those CXO level hires and the salaries and perks that such positions enjoy, you can expect that fund houses will be seeing a dramatic increase in their operational costs. Where do you think that money is going to come from?  Let's hope for the best but also be prepared to shell out potentially higher fees by way of a higher expense ratio (which is the fee you pay to the fund house for managing your capital).

• Rationalised returns from mutual that need to correct course

For mutual funds that have been blurring lines in risk management commitments, colouring outside the lines or blatantly breaking the rules, forced adherence might mean rationalised returns in the short run, as new strategies need to be figured out.

• Safety in the long run

Investors can expect a higher level of adherence to the published risk profile that mutual funds say that they have. As such investors will not be accepting more risk than they bargained for without knowing it.

Conclusion:

SEBI has operated to protect investors throughout and now with several changes in the risk management framework will generate more relief for the investors of mutual funds.