Entities Involved in Mutual Fund Part 2

The Fund Sponsor : The trustees have a critical role to play as they are directly responsible to the investors/unit holders in the mutual fund. The trustees in turn appoint the asset management company (AMC). The AMC conducts the business of managing the day-to-day administration and fund management activities as also marketing and sales.

The Trinity that guards the investors

It is apparent from the above 3-tier structure that the sponsor has little or no role to play in direct fund management. From the investor's perspective investor’s mutual fund schemes are managed by the AMC, which is run professionally and has a Board of Trustee to report to.

The sponsor is required to contribute at least 40% of the minimum net worth (Rs. 10 crore) of the Asset Management Company and posses the sound track record over the last five years prior to registration. The board of trustees manages the MF and the sponsor executes the trust deeds in favor of the trustees. It is the job of the MF trustees to see that schemes floated and managed by the AMC appointed by the trustees are in accordance with the trust deed and SEBI guidelines.

This is quite unlike a corporate structure where the promoter  in most cases is directly involved and responsible for the day-to-day functioning of the company. Therefore the stock price is directly related to the events affecting the promoter.

The experience and track record of the sponsors should be such as to give confidence to potential investors. Their reputation for investor friendliness, transparency, regulatory compliances, etc should be verified in detail. The offer document would contain details of all regulatory actions and investigations against the sponsors within the country and abroad. They should be studied in detail to understand the seriousness of the alleged offences. The possible financial impact of adverse regulatory rulings on the sponsors should also be understood.

Promoters or sponsors of the fund are not allowed to influence the investment decisions of the fund. Once the fund is operational, they are expected to retreat to the background and let the fund managers handle the operations of the fund. However, they appoint the fund managers and are responsible for ensuring that the fund management is carried out in the best interests of the investors with complete integrity and transparency.

If the sponsor or one of the sponsors is a foreign entity, the reputation and track record in its home country should be studied. Many of the prominent foreign fund managers operating in Indiaare well reputed globally and each of them has its own distinct investment philosophy. It is advisable to see if their fund management philosophy matches investor’s outlook and requirement.

Financial performance of the sponsors for the previous three years would be provided in the offer document. Consistently good financial performance over the years would be a good indicator to the capabilities of the sponsor.

Mutual Funds as Trusts:  A mutual fund in India constituted in the form of a Public Trust created under the Indian Trusts Act, 1882. The fund sponsor acts as the settler of the trust, contributing to its initial capital and appoints a Trustee to hold the asset of the trust for the benefits of the unit holders, who are the beneficiaries of the trust. The fund then invites investors to contribute their money in the common pool by subscribing the units issued by various schemes established by trust units being evidence of their beneficial interest in the fund.

Trustees: Trustees are board members of the mutual fund trust. They should be persons of good capability and standing and should not have been convicted for any economic offence. At least two thirds of the trustees shall be independent, or in other words they should not be associated with the promoters. No person can serve as the trustee of more than one mutual fund, unless he is an independent trustee. Trustees can be individuals or companies.

Trustees are responsible for the overall management of the mutual fund. They hold all assets of the mutual fund on behalf of its investors and it is their job to ensure proper management of such funds. Trustees are not allowed to manage the funds or take investment decisions themselves. Their responsibilities include appointment of fund managers, ensuring all legal compliances, appointment of auditors, establishment of internal controls, supervision of fund management, etc.

Trustees are required to carry out frequent checks on the activities of the fund and its managers. They are also required to report about the activities to SEBI, once every six months. A compliance officer should be appointed by the trustees to ensure that all legal provisions are adhered to.

Independent Trustees : Mutual fund trusts are required to have a majority of independent trustees on the board of trustees. The independent trustees are appointed to ensure that the promoters do not exert any influence on the decisions of the fund managers and that the best interest of investors is the guiding principle in all investment decisions.

Promoters can get away by appointing their own men as independent trustees. Therefore, it is important that the independent trustees are individuals of known integrity and competence. Ideally, they should be individuals with considerable corporate experience at the director board level and who are known to have an independent mind.

Asset Management Company (AMC) : AMC’s manage the investment portfolios of schemes.  An AMC’s income comes from the management fees it charges to the schemes.  The management fee is calculated as a percentage of net assets managed.  Some countries provide for performance based management fees as well.

In order to earn the management fee, any AMC has to employ people and bear all the establishment costs that are related to its activity, such as for premises, furniture, computers and other assets, software development, communication costs etc.  These are to be met out of the management fee earned. Expenses such as on trustee fees, marketing etc. can be directly borne by the mutual fund scheme.  However, in some cases, competition in the marketplace could force an AMC to bear some of these costs, which would otherwise have been borne by investors in the schemes. So long as the income through management fees more than covers its expenses, an AMC is economically viable. 

Given the nature of the activity, a certain minimum establishment and infrastructure is necessary for an AMC’s functioning.  Since costs cannot be reduced below a base level, AMCs need to have a reasonable corpus of assets under management (AUM), below which it may not be viable. The breakeven level of AUM is a function of cost structure of the AMC and distribution of assets between schemes (debt schemes and index schemes generally yield a lower management fee).  As a thumb-rule, in the Indian context it is difficult for an AMC to breakeven if its AUM is below  Rs 2,000crore.

Distributors : Distributors earn a commission for bringing investors into the schemes of a MF.  This commission is an expense for the scheme, although there are occasions when an AMC chooses to bear the cost, wholly or partly.

Depending on the financial and physical resources at their disposal, the distributors could be:

1. Tier 1 distributors (having an owned or franchised network reaching out to investors all across the country); or
2. Tier 2 distributors (regional players with some reach within their region); or
3. Tier 3 distributors (marginal players).

It is paradoxical that distributors earn a commission from the AMC, but are expected to safeguard the financial health of investors from whom they do not earn a fee.  It is almost like a doctor earning a commission from the pharmaceutical company, but expected to safeguard the physical health of the patient who does not pay him anything.

In recognition of the anomaly in the distribution structure, a body of financial planners is expected to emerge in the Indian financial market.  They will safeguard investor’s interest in return for a fee from the investor. 

Registrars and Transfer Agents : The investor’s holding in schemes is typically tracked by the scheme’s Registrar and Transfer agent (R&T). Some AMC’s prefer to handle this role in-house. The registrar / AMC maintain an account of the investor’s investments in and dis-investment from the scheme.  Requests to invest more money into a scheme, or to recover moneys against existing investments in the scheme are processed by the R&T.

Since the database of investors is maintained by the R&T, internet based transactions of existing investors in the schemes of an AMC are effected through the R&T’s database servers. Records of unit holders determine the scheme’s unit capital (discussion follows), which is a significant component of the liability side of any MF scheme.

Custodian / Depository : The custodian maintains custody of the securities in which the scheme invests (as distinct from the registrar who tracks the investment by investors in the scheme).  This ensures an ongoing independent record of the investments of the scheme.  The custodian also follows up on various corporate actions, such as rights, bonus and dividends declared by invested companies. In a situation where securities are increasingly being dematerialized, the role of the depository for such independent record of investments is growing.

In the recent securities market scam, a large investor parted with some of its funds without gaining custody of the securities where they were supposed to have invested.  When the scam broke out, they realized that the money was gone, but they did not have the securities.  The custodian in the MF structure is in a position to prevent such risks.