When you require money, do you ask your brother/sister for cash? Many cash-strapped adults do tap siblings in a desperate bid for money. Turns out that your mutual fund manager and mutual fund scheme too have been adopting similar tactics when money is required. Funds use the inter scheme transfer route to sell assets to a ‘sister/brother fund’ of the same parent fund-house, and use that money to honour redemptions. What’s wrong in that, you ask? Plenty. There have been documented instances of a credit risk fund ‘selling’ assets to a Fixed Maturity Plan (FMP) to meet redemptions, a credit risk fund ‘selling’ assets to a hybrid fund, a credit risk fund ‘selling’ assets to a balanced advantage fund.

This legal ‘hera pheri’ loophole previously existed without much restrictions. Hence, it was open to abuse. To facilitate the exit of one set of investors, sub-optimal securities were dumped on another scheme. Many a times, poorly rated assets fund their way to a scheme, whose investors did not want exposure to inferior assets. The good thing is that now regulator SEBI has finally woken up to all this and tightened rules on inter scheme transfer. This makes mutual funds a safer place. Read on to know more.

Inter scheme transfers

Inter scheme transfers are, atleast on paper, done in line with regulatory requirements and applicable internal policies as determined by the valuation committee of a fund-house. The problem with inter scheme transfers is the potential for abuse. They have been, in some instances, used for transferring illiquid securities from one scheme to another. In a scenario where there is a deficit of money at a scheme level, low-rated papers can be shifted out and for that a scheme from the same fund-house pays money. The risk is transferred smoothly. Fund-houses say that the inter scheme transfer(s) are undertaken as per the AMC’s internal process, procedure & methodology.

When Covid-19 struck Indian financial markets in March and April, one fund-house i.e. Franklin Templeton announced six debt schemes would be shut down, but others did not utter much. A look at inter scheme transfer data, available on SEBI website, shows why other fund-houses were silent. Facing redemption pressures, many fund-houses resorted to such deals. In March, April and May 2020, there were 2,000 odd deals alone with a total value of Rs 57,000 crore. Between Apr-Aug, mutual funds did over 2,400 such inter scheme deals concerning corporate bonds worth more than Rs 60,000 crore. When problems came home, schemes of a fund-house did these deals to hide problems.

Check out the data below to see the monthly transactions.

Source: https://www.sebi.gov.in/statistics/corporate-bonds/interarchivestransfercorporate.html

Tightened norms

In the wake of all this, SEBI has now tightened inter scheme transfer norms for mutual funds. The new norms will come into force from January 1, 2021. So, fund-houses still can do many such deals.

Close ended schemes – SEBI has said that inter scheme transfer purchases would be allowed only within “three” business days of allotment pursuant to New Fund Offer (NFO). Thereafter, no such transfers shall be permitted to/from close ended schemes. This is important for Fixed Maturity Plans (FMPs), a close ended scheme type.

Impact – To meet redemptions from open ended mutual fund schemes, fund-houses were previously using FMP money in a serpentine way. We have seen how illiquid bonds were shifted from a credit risk fund to an FMP. FMP investors can’t exit until the final closing date of the FMP and suddenly, if such a fund bought questionable corporate bonds, investors had no way to escape. In effect such deals made use of FMPs as cash cows for redemptions. Now, with the SEBI’s tightened norms, FMPs cannot be touched as recipients of shady inter scheme transfers.

Open ended schemes – SEBI has mandated that open ended schemes will be permitted to inter scheme transfers to manage unanticipated redemption pressure, but inter scheme transfers should be the last option. Open ended funds finding difficulty in honouring redemptions will have to use scheme cash & cash equivalents, use market borrowing and sell securities in the market. In case the fund does not use the option of market borrowing or selling of security, the reason for the same will have to be recorded with evidence.

Impact – Borrowing money in the MF world is a bad signal. In fact, when schemes have to borrow money to meet redemptions, investors understand the problem. By making inter scheme transfer virtually the last option to raise cash, mutual funds cannot use this route without exhausting or exploring the other avenues. SEBI has basically directed funds to ‘beg, borrow’ before doing ‘inter scheme transfers’.

Balancing – SEBI has directed that inter scheme transfers shall be allowed only to rebalance the breach of regulatory limit. Such transfers can be done where anyone of duration, issuer, sector and group balancing is required in both the transferor and transferee schemes. Importantly, SEBI has said, different reasons cannot be cited for transferor and transferee schemes except in case of transferee schemes being a credit risk scheme.

Also, in order to guard against possible mis-use of such transfers in credit risk schemes, trustees shall have to ensure a mechanism is in place that negatively impacts the performance incentives of fund managers, chief investment officers (CIOs), etc. This is for those involved in the process of transfers in credit risk schemes, in case the security becomes default grade after the transfer within a period of one year. Such negative impact on performance shall mirror the existing mechanism for performance incentives of the AMC.

Also, if a security gets downgraded following transfers within a period of four months, the fund manager of the buying scheme has to provide detailed justification/rationale to the trustees for buying such security.

Impact – Credit risk schemes have used inter scheme transfers to escape the ire of redeeming investors. But, that has been done at a cost of other schemes. SEBI has now ring-fenced the use of such transfers by laying down stricter norms.

Also, by linking performance pay of fund management team to questionable inter scheme transfers (where the security transferred eventually gets default grade post-transfer), the regulator has tried to stop such deals and save investors in the transferee scheme. The regulator is ensuring that if risks are smoothly transferred from one scheme to another, the fund management team is held accountable for such deals.

Rumour – No inter scheme transfer of a security will be allowed, if there is negative news or rumours in the mainstream media or an alert is generated about the security, based on internal credit risk assessment, SEBI has said.

Impact – Basically if there is negative news about a company, even something like ‘rumours, then an inter-scheme transfer will not be allowed. This further stops any attempt by fund managers to be ‘first out of the gate’ and in the process dumping such a security on a fellow scheme.

RupeeIQ take

We have no problem with genuine inter scheme transfers. These deals do not favour any set of investors over the other.

SEBI’s latest move on the bad apples of inter scheme transfer space can lead to enhanced accountability on the part of the concerned fund house.

We like the fact that the fund management team of both the transferor and transferee scheme will be under the scanner. Such monitoring and norms will compel fund-houses to have better risk management systems. Purchasing and liquidating poorly-rated or illiquid security can no longer be justified easily in inter scheme transfer deals.

Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at [email protected].

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