Mutual funds beyond returns

They have an important role in improving corporate governance and deepening the corporate bond market

The Indian mutual fund industry has been a success story in inculcating a culture of capital investment across the country. The industry got a further boost in recent years. The low interest rates kept by the Reserve Bank of India (RBI) for over two-and-a-half years after the onset of the pandemic in March 2020, resulted in negative real returns from bank deposits, and pushed savers to become investors in the capital markets. A large proportion of this investment came through the mutual fund (MF) route. To have some perspective, the assets under management (AUM) of MFs, which were Rs 8.25 trillion as of April 1, 2014, grew to Rs 39.89 trillion by December 31, 2022 — an increase of 383 per cent. The growing heft of MFs in the financial sector can be gauged by the fact that their AUM stood at about 30 per cent of the total outstanding bank loans as of December 31, 2022.

The increased participation of MFs, other domestic institutional investors and individuals in the capital market also helped in keeping the Indian stock markets relatively stable during the last few years, which saw significant foreign portfolio investment (FPI) movements. Of course, with the real bank deposit returns turning positive in the last few months, MFs have their task cut out in keeping investors interested in their schemes.

MFs hold people’s money in fiduciary capacity and are duty bound to act in the interest of the investors. But can simply buying and selling of securities on a day-to-day basis be their only role? Certainly not.

As regulated institutions, and considering their size of investments, they can and should play an important influencing role in improving the corporate governance of the investee companies and in facilitating desirable changes in the structure of the securities market. Besides benefiting the investors in their own schemes, their actions on these fronts could result in public good. Many of the regulatory changes brought in by the Securities and Exchange Board of India (Sebi) in the last few years have been with a view to encourage and guide the MFs towards this. For the purposes of this article, let’s separately look into such roles of MFs while they invest in equity and debt securities.

Illustration: Binay Sinha

The total AUM of MFs under equity schemes  was Rs 15.32 trillion as of December 31, 2022. The average holding of individual investors and MFs in listed companies stood at around 7.3 per cent and 8 per cent, respectively, as of September 30, 2022. In a joint stock company structure, all investors are part owners of the company. The part ownership comes with the responsibility to have an oversight over the affairs of the investee company. This reality must sink in amongst the individual investors and MFs.

The MFs have an important stewardship role to play in improving the corporate governance practices of the investee companies. As trustees of people’s money, they can’t afford to be passive investors — they ought to keep a vigilant eye on important events that impact/may impact investors’ interests, and take appropriate timely actions.

Sebi’s guidelines of 2021 mandate the MFs to compulsorily vote on resolutions, brought for voting before shareholders, by investee companies. This prescription had to be made as it was realised that many MFs were often “abstaining” from voting on a large proportion of companies’ resolutions. Another revelation was that the percentage of voting “against” resolutions was rather minuscule. Some MFs had never voted “against” and some had always voted “for” on all resolutions.

It would be interesting to study the MFs’ actual voting behaviour after these Sebi guidelines. For instance, one may like to see the logic, if any, in case different MFs, which have invested in a company, vote differently on a particular resolution of that company. Another important aspect would be to learn as to how the MFs vote on resolutions of related companies, i.e. the companies having the same sponsors/promoters as those of the participating MFs.

Coming to debt security investments, the MF’s total AUM, as of December 31, 2022, was Rs 12.65 trillion. This is sizeable considering that the underlying corporate bond market in India is underdeveloped and at times illiquid. As compared to the equities market, the institutions like MFs need to play an even more meaningful role in developing and improving the credibility of the corporate bond market.

MFs are the most active participants amongst various institutions in the corporate bond primary market, especially in bonds rated below AAA, and also in the secondary market transactions. During 2021-22, MFs were involved as buyers and sellers in about 30 per cent of the total corporate bonds trading volume. In fact, in the lower rated bond market, whatsoever liquidity is available, it is on account of MF’s trading.

As of now, MFs offer the best bet for deepening the bond market in India and they need to be encouraged as such. Their success is likely to attract other institutions and non-institutions to the corporate bond market. Of course, as holders of public money, they have to be prudent, transparent and responsible in deciding their portfolios and can’t afford to throw caution to the wind.

Sebi has brought in substantial reforms in the last few years in regulating MF debt schemes. These include — transparent valuation methodology, allowing side-pocketing, swing pricing, making MFs to have skin in the game, and clarifying that the MFs can’t have standstill arrangements with the issuers. The MFs are also mandated to participate in the “request for quote” platform of the stock exchanges for a certain percentage of their trading. This has brought in some transparency in trading of bonds and in price discovery. All these measures haven’t only strengthened the MF regulatory framework but also improved investors’ confidence in the corporate bonds market. 

While this article is focused on MFs’ role in improving the corporate governance of their investee companies and in deepening the corporate bond market, similar role needs to be played by other regulated financial institutions, such as banks, insurance companies and pension funds while investing in the markets.

In fact, insurance companies and pension funds being long-term investors can play an even more significant role. The Insurance Regulatory Development Authority of India and Pension Fund Regulatory and Development Authority have issued stewardship codes for their regulated entities, as also the instructions about their participation in the bond market. It will be useful if these regulators comprehensively review the actual performance of their regulated entities and persuade them to be more proactive in this regard.

The writer is a former IAS officer and Sebi chairman