Franklin Templeton crisis: What regulators should do to win back investors' confidence

Regulators can design a system where all fund managers should be ranked based on their past performance and process procedure basis, which is different from the fund house

SEBI has now sought details from the industry on its debt scheme portfolios SEBI has now sought details from the industry on its debt scheme portfolios

Since the declaration by Franklin Templeton of winding-up 6 of their funds, there has been an outflow (net redemption) of Rs 19,000 crore from debt funds and another Rs 14,000 crore from short end funds. This is despite Rs 27,000 crore of fixed maturity plans (FMPs) that matured in the same period which usually get deployed into other funds.

The initial step came as RBI recently opened a Rs 50,000 crore special liquidity window for mutual funds (MFs) to give a line of credit to the industry in light of the anticipated heightened redemption pressure. This was not only for the higher risk "Credit Schemes" but for other categories as well, given that there is a liquidity mismatch that exists: i.e. the maturity profile of the underlying papers that the MFs hold may not be in keeping with the investment tenor of these MF investors.

SEBI has now sought details from the industry on its debt scheme portfolios. Other details sought by SEBI include details of the underlying securities, their ratings, maturities, tenures of schemes and their mismatches, redemption trends, commissions, and fees earned by asset management companies (AMCs) and distributors from the sale of such schemes.

Also Read: Franklin Templeton crisis: SEBI needs to take investors' interest seriously

Loss of investor confidence will affect the economy as a whole: Without the presence of a vibrant bond market, MFs were a source of funding for a lot of companies, tapping retail investors given the tax advantage and the perceived superior credit analysis that MFs provided.

We see the following steps as things that regulators should immediately implement to restore confidence:

1. Scheme Wind-down Permission:

No MF Scheme can be launched without taking specific approval from SEBI to launch it. This includes a host of information that the regulator vets before it grants permission to an AMC to launch and gather funds.

Similarly, there must be a process before an AMC can wind-up a scheme.

It should give reasons for the same, and what measures it has taken to safeguard investor interest.

Regulators can look beyond this to see possible contagion effects, and maybe have time to take pro-active steps (like the liquidity window) rather than scramble to contain the situation post an event.

2. Reclassification of Debt Funds

At present, the fixed income funds are classified in terms of underlying maturities e.g. overnight, liquid, liquid plus, short term, etc. There is no classification in terms of underlying credit papers going beyond some overall restrictions.

This may be due to the assumption that AMCs and fund managers would understand that shorter-term funds (say liquid plus) would not take papers that may be at higher risk, given that requirements of investors is liquidity and liquidating even lower credit rating shorter term papers would be difficult in times of stress.

This may not be true: the FT Ultra Short Bond fund is also one of the funds that is being wound up.

Getting a more detailed reclassification, categorising credit, as well as Tenor, may help investors better understand the risks.

3. Have a Qualified Investor category

At present, there is no restriction on the type of investor who can invest in which category of funds.

Higher risk categories should be pitched to people who have a better understanding of the risks involved.

Just like in PMS and AIF, where the minimum investment is higher, there must be differentiation in MF schemes, based on underlying risk. So that those investing are not retail investors.

As mentioned, there is a big difference in the type of risks that two schemes, with similar-sounding names (e.g. Ultra Short Fund), can have.

Also Read: Mutual funds in troubled waters: Decoding Franklin Templeton fiasco

4. Monitoring and Penal action

Monitoring the underlying securities in a fixed income scheme, and basic parameters for e.g., the liquidity profile of the underlying security, a stress test on asset quality, etc., must be monitored more.

Any mismatch in the regulatory requirement e.g. average maturity being significantly higher than permitted for that category should attract penal action by regulators.

5. Ranking & Rating for Fund Managers

Regulators can design a system where all fund managers should be ranked based on their past performance and process procedure basis, which is different from the fund house. This transparency/ranking and rating will help investors take an informed call on the fund managers.

6. Risk Category

Regulators should redefine the risk colour category as this will bring awareness among investors regarding the risk factors of debt schemes. Currently, the Franklin Templeton crisis has put all investors in panic mode. As per the current regime, short term debt funds are in the green category indicating safety.  It is high time regulators review whether they can still continue to define any debt scheme in the green zone.

7. Managing the Total expense Ratio

The 6 wound up funds still continue to have management expenses, which are 0.64% for the credit fund, to 0.86% of the dynamic accrual fund. Given unilateral decisions by the AMCs to wind up their funds, these expenses continue to be charged to the investors. Regulators should strictly control such fees that AMCs continue to earn.

Actions like the above by regulators will help restore the confidence of investors.

(George Mitra is CEO and Co-founder and Rajan Pathak, MD and Co-founder, Fintso)