Is a mutual fund legally liable if it deviates from its advertised investment strategy?
06 Apr 2021
Mutual fund schemes are categorised as belonging to a particular SEBI specified category (e.g. Short term, medium term, large cap etc) and following a pre-specified investment strategy such as investing in financial instruments of a specific duration. People investing in these schemes also plan their investments and taxation on the basis of the investment strategy and category of the scheme. However, how far is the mutual fund legally bound to follow its declared investment plan? Know the fine print before you invest.
Fund categorization and liability of the MF
Earlier, prior to October 2017, there used to be cases of wide disparity between the name of the fund, what it stands for, and the implemented strategy and portfolio construct. As an example, a large cap fund (as per name) could invest in small cap stocks and vice versa. Alternatively, a long duration bond fund (by name) could invest in short maturity instruments and vice versa.
The governing principle used to be the investment universe mentioned in the Scheme Information Document (SID); as long as the portfolio components were within the universe, the MF was legally safe. Then came the SEBI categorization norms in October 2017, which got implemented gradually from April to June, 2018. Now the SEBI norms outline what a fund in a particular category can do, which implies a fund cannot go beyond that. The concept of investment universe mentioned in the SID is still valid but now it has to be within the SEBI rules for that category. In other words, the SEBI rules are the “set” and the SID definition is a “sub-set” within that category. As an example, in the debt fund category called Banking and PSU Funds, SEBI rule states that minimum 80% of the portfolio has to be invested in instruments issued by Banks/PSUs, which is the “set”. Additionally, within that “set”, the MF can define a “sub-set” that instruments with a minimum credit rating of “X” will be taken in the portfolio.
From the investors‘ perspective, it is advisable to go through the SEBI norms (available on SEBI website) for that category and the MF’s investment objectives mentioned in the SID (available on the AMC’s website) for the scheme that he/she wants to invest in. Legally, that is the binding contour for that fund.
Positioning of a fund within the broad mandate
Within the broad mandate discussed above, there may be a “sub-positioning” by the AMC for a particular fund. As an example, a debt fund may be positioned as maturity roll-down fund where the portfolio maturity is gradually rolled down. This may be mentioned in the product literature of the fund or fund factsheet. As mentioned earlier, what is mentioned in the SEBI fund categorization rules and in the SID for the fund is legally binding. Something mentioned in some other communication may not be a legal obligation. However, if a MF violates what is known as true-to-label, it would be breaking the trust and faith of investors and distributors, hence unlikely to breach the soft boundaries. However, do remember that you would not be able to take a MF to court as long as it operates within the SEBI defined category rules and its own SID but does not adhere to plans spelt out in other documents.
Why portfolio maturity or duration can be deceptive
Investors need to be aware of what is the connotation of portfolio maturity. As per SEBI rules, the portfolio maturity (or portfolio duration which is a technical variant of the concept of maturity) is defined as the average of all instruments in the portfolio. Hence, individual instruments may be of a much longer maturity. There is a technicality here: the Macaulay Duration of an instrument with put option, as a convention, is calculated as per the put option date and for floating rate instruments, the rate-reset frequency is taken as maturity. As an example, when Franklin Templeton shut down six of its funds, we learnt that many instruments in its portfolio are of much longer maturity than the portfolio Macaulay Duration. As per SEBI categorization norms, the “Duration” of an Ultra Short Term Fund should be in the range of 3 to 6 months, and Franklin Ultra Short Term Fund had a Macaulay Duration of less than 6 months. However, that is the average of all instruments in the portfolio and the “Duration” was computed as per the convention mentioned above.
From the investors’ perspective, it is difficult to find out the security-wise maturity or duration; the fund factsheet mentions the portfolio average data. In two debt fund categories, Liquid Funds and Money Market Funds, the maturity is defined as per individual instruments and not just portfolio average. In Liquid Funds, the maximum maturity of an individual security can be maximum 91 days and in Money Market Funds it is maximum 1 year, as per SEBI rules.
Fixed Maturity Plans (FMPs) are listed at the Exchange as per rules, but liquidity is lacking. Investors should invest in FMPs only if there is a clear investment horizon matching the maturity of the FMP. In the secondary market, FMP units can be sold only if there is a buyer at a rightful price. There is no redemption with the AMC as per regulation. In ETFs, there is reasonable liquidity in the secondary market. In all other open-ended funds, there is redemption with the AMC without any conditionality.
(The writer is a corporate trainer (debt markets) and author.)