Demystifying SEBI’s Regulations- How Your Mutual Fund Investments Are Protected?

Mutual Funds have witnessed a remarkable surge in popularity as an investment choice in India in recent decades. As per recent reports from The Association of Mutual Funds in India (AMFI), the total money managed by Mutual Funds has crossed Rs 46 lakh crore, with a more than 6-fold increase in 10 years.

This huge growth happened because of a mix of reasons. First, more people now know about Mutual Funds and how they work. Thanks to the increased awareness of Mutual Funds and all the finfluencers. Second, there have been changes in the rules and regulations that have made Mutual Funds better.

But there’s a question that often comes to our minds:

How secure are Mutual Funds?

Is there a risk of losing our money completely?

What are the regulations in place that govern these Mutual Funds?

In this article, we will see how Mutual Funds have evolved and how the regulations put forth by SEBI are benefiting the commoners. Let’s explore.

Table of Contents

I. The Evolution:

1. First Phase -1964-1987:
2. Second Phase – 1987-1993 – Entry of Public Sector Mutual Funds
3. Third Phase – 1993-2003 – Entry of Private Sector Mutual Funds
4. Fourth Phase – Since February 2003 – April 2014
5. Fifth (Current) Phase – Since May 2014

II. How is a Mutual Fund constructed in India?

1. Who exactly owns the Mutual Funds?
2. Role of AMC
3. Safety in Mutual Funds

III. The Path to a Fraud-Resilient Mutual Fund Industry

1. The Changing Landscape of NFOs: SEBI’s 2006 Decision
2. Abolition of High Agent Commission and NFO Fee
3. Why did this upfront charge matter?

V. 2013-the Birth Of The Direct Mutual Funds.

1. Growth of Professionalism
2. Link Between Long-Term Investment and Trial Commissions
3. SEBI Regulations – The Aftermath

VI. 2019: Trimming down Expense Ratios
VII. 2020: Categorizing Mutual Funds

1. Introduction of Different Caps
2. Introduction of Risk-o-Meter:
3. How is the risk calculated?
4. Why these regulations?

VIII. Insurance Policy Regulations vs. Mutual Fund Regulations

1. Agent Commissions – Insurance vs. Mutual Funds
2. What makes Mutual Funds stand out from the other products?
3. ULIPs vs. Mutual Funds – Rewards and Categorization

IX. Conclusion

I. The Evolution:

Before we can see how SEBI has put in place the regulations for this product, it is imperative to see how the Mutual Fund has evolved all through these years and the changes it has gone through.

• First Phase -1964-1987:

The Mutual Fund industry in India began in 1963 when UTI (Unit Trust of India) was established by an Act of Parliament. Initially, it operated under the supervision of the Reserve Bank of India (RBI).

However, in 1978, UTI became independent of RBI, and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative responsibilities of RBI.

UTI introduced its first scheme called Unit Scheme 1964 (US ’64). By the end of 1988, UTI managed assets worth ₹6,700 crores.

• Second Phase – 1987-1993 – Entry Of Public Sector Mutual Funds

In 1987, public sector Mutual Funds, initiated by Public Sector banks, Life Insurance Corporation of India (LIC), and General Insurance Corporation of India (GIC), entered the scene.

SBI Mutual Fund was the pioneer among non-UTI Mutual Funds, starting in June 1987, followed by Canbank Mutual Fund (Dec. 1987) and others.

LIC introduced its Mutual Fund in June 1989, and GIC established one in December 1990. By the end of 1993, the Mutual Fund industry managed assets worth ₹47,004 crores.

• Third Phase – 1993-2003 – Entry Of Private Sector Mutual Funds

In April 1992, the establishment of SEBI marked a significant moment for the Indian securities market. SEBI was created to safeguard investor interests, promote market development, and regulate the securities market.

Kothari Pioneer, which has since merged with Franklin Templeton MF, became the first private-sector Mutual Fund to be registered in July 1993.

The initial SEBI MF Regulations were later replaced by the comprehensive SEBI (Mutual Fund) Regulations, 1996, which are still in effect.

• Fourth Phase – Since February 2003 – April 2014

In February 2003 UTI underwent a division into two distinct entities. The Specified Unit Trust of India operated independently of Mutual Fund Regulations and was under the exclusive management of the government.

UTI Mutual Funds, sponsored by SBI, LIC, PNB, and BOB, emerged.

SEBI undertook a lot of efforts in instilling confidence amongst the investors in this period. The inflow started increasing and it was the beginning of something big in the Indian Mutual Fund industry.

• Fifth (Current) Phase – Since May 2014

More initiatives were brought to the people thereby building trust.

These initiatives were aimed to revitalize the Indian Mutual Fund industry and enhance its reach.

Over time, these measures effectively reversed the adverse trajectory that had emerged following the global economic downturn in 2008.

Before we get into the details of how SEBI built this fraud-resilient industry, let us see what exactly a Mutual Fund is, who owns it, and who regulates the Mutual Funds.

II. How is a Mutual Fund constructed in India?

In India, Mutual Funds operate with a three-tier structure. There’s the sponsor, the trust, and the asset management company (AMC). The goal is to ensure that neither the sponsor nor the AMC can run off with our money.

The funds are held by a trustee company or a board of trustees. The trust rules in India are strict. If anyone is found guilty of fraud or misusing investor funds, they could lose their assets and even end up behind bars. So, there’s a strong incentive to play by the rules.

• Who exactly owns the Mutual Funds?

It’s the sponsor. They set up the Mutual Fund business to make a profit.

For instance, SBI Mutual Fund’s sponsors are SBI and Amundi from France. HDFC Mutual Fund has HDFC and ABRDN Investment Management Ltd. as sponsors. And for Mirae AMC, it’s the South Korean Mirae Asset Global Investments Co. Ltd.

• Role Of AMC

Now, the sponsor has created a company to manage the funds, which is called the asset management company (AMC).

This AMC is essentially the Mutual Fund itself. The AMC charges a fee for its services, and the money from investors is held by the trustee company. This money is then invested in various things like stocks, bonds, gold, and other assets allowed by the regulator.

• Safety in Mutual Funds

As Mutual Fund investors, we should understand this structure to know that our money is safe from someone running away with it.

Thankfully, in the history of regulated Mutual Funds in India, there hasn’t been a case of a Mutual Fund AMC running off with investors’ money.

Fund managers can still make mistakes, or engage in practices like front-running and other issues, but be rest assured that our money cannot be swindled.

III. The Path to a Fraud-Resilient Mutual Fund Industry

SEBI, since its inception in 1993, took over the responsibility of building a robust system for retail investors.

It started building several foolproof mechanisms that reduced the risks of investing in Mutual Funds. This will also build a trust factor amongst the people.

Let us now look in detail at how SEBI made this a foolproof system safeguarding our money.

• The Changing Landscape of NFOs: SEBI’s 2006 Decision

The first and foremost aspect for any product or any industry to flourish is to break the entry barriers. When entry barriers are lowered or eliminated, it fosters an environment where new players can enter the market, leading to increased competition, diverse products, and improved services.

If you had the thought of entering the Mutual Fund industry in this period and decided to make an NFO purchase, then you would have to shell out ~9 % additional amount in just commissions to the agent.

• Abolition of High Agent Commission and NFO Fee

One major entry barrier that SEBI demolished was the abolition of the 6% fee for the NFOs. Before 2006, Mutual Funds were allowed to charge investors a substantial 6 percent of their investment in marketing and distribution costs for NFOs.

Additionally, there was an upfront charge of 2.25 percent for every Mutual Fund scheme purchased.

So all put together, the total agent commission was around 9 %. It was essentially an incentive that went to Mutual Fund agents who just felicitated the transaction between the investors and the fund houses.

This practice resulted in investors not only losing money due to hefty commissions but also contributed to a churn scam. In this scheme, agents convinced investors to put their money into funds with substantial commission percentages. They encouraged frequent buying and selling of these funds, primarily to reap the benefits of these commissions for themselves.

• Why did this upfront charge matter?

Firstly, lower commissions meant that many investors could invest at a lower cost rather than giving about 6 % to the agents.

Secondly, this stopped the churn in the portfolio of the investors. It’s a well-known fact that Mutual Funds perform better when they have the chance to compound over several years of investment. By lowering this fee, SEBI has provided investors with the opportunity to hold onto the fund for an extended investment horizon.

It also succeeded in generating greater interest among the public as the assets under management in Mutual Funds increased from Rs 3.23 trillion in late 2006 to Rs 4.13 trillion by the end of 2008.

This was one of the major roadblocks that was cleared by SEBI.

IV. 2009: SEBI Removes the Upfront Commissions

As in the above section, the front load fee was also abolished by SEBI. This fee was quietly deducted by the Asset Management Company (AMC) and directed to the agent responsible for selling the product.

This front load fee was in addition to the expense ratio that the AMCs levied on the investors.

As a result, SEBI made the Indian Mutual Funds the first in the world to become no-load funds.

The industry reacted negatively as the AUM dipped after this announcement. However, the inflow quickly rebounded, and the move to abolish the upfront commission paid off.

V. 2013-the Birth Of The Direct Mutual Funds.

Starting from January 1, 2013, investors had the option to bypass agents and invest directly in mutual Fund schemes. These changes benefited investors by avoiding trail commissions to agents.

Though the lack of expert opinion is a drawback, these funds had lower costs compared to the regular plans sold through agents.

The costs in direct plans were lowered to at least match the difference in costs compared to regular plans. This made direct plans, on average, about 0.5% cheaper.

The expense ratio was only the tip of the iceberg. The underlying benefit was much larger.

• Growth Of Professionalism

The direct funds served as a countermeasure against amateur Mutual Fund distributors. Prior to this regulation, many distributors were simply selling funds without a genuine commitment to client welfare. The absence of client-centered practices often leads to misaligned interests and potential mis-selling of financial products.

The introduction of direct Mutual Funds brought about a paradigm shift. Distributors were now expected to provide value-added services, risk profiling, conduct in-depth reviews, and genuinely cater to the best interests of their clients. This shift in approach separated the serious professionals from those who were only in it for commissions.

This change aligned the interests of distributors more closely with those of investors, promoting a culture of responsible financial planning and genuine wealth-building opportunities.

• Link Between Long-Term Investment and Trial Commissions

Just like previous regulations, there were predictions that the industry would perish. People said investors would turn to parts of the market without regulations!

But, by the end of 2018, the assets under management had reached Rs 22.86 trillion.

Over time as the investors’ wealth increased, the trial commissions also grew because they are a percentage of the total portfolio. This motivated the agents to encourage long-term investment, particularly in equities, as they could earn around ~ 0.5 % of the total assets under management as a trial commission each year.

• SEBI Regulations – The Aftermath

While long-term investing is good, long-term investing in the wrong Mutual Fund may only earn mediocre returns. A Professional Mutual Fund Distributor or a Financial Planner can help you select the right Mutual Fund for you.

The Trail Commission paid to him creates a Win: Win Situation. Only if the client’s portfolio grows, the agent’s incentive will grow. If the portfolio goes down, the agent’s commission will also go down. This forces the agents to work in the best interest of their clients.

So, one thing is for sure, all the regulations that the SEBI had put in only eased investing and increased the overall AUM of the funds.

VI. 2019: Trimming down Expense Ratios

The expense ratio is the percentage that denotes the amount of money you are paying to the AMC as a fee to manage your investments. In other words, it is the per-unit cost for running and managing the Mutual Fund.

As Mutual Funds grow, their fixed costs tend to remain relatively constant, and there isn’t a significant increase in expenses as more money is managed. Logically, this should result in a noticeable decrease in the expense ratio for large funds.

However, SEBI noticed that the expense ratios were either kept unchanged or were increased.

In yet another cost reduction, SEBI fixed an expense ratio of 1.05 percent for equity schemes with assets exceeding Rs 50,000 crore and 0.80% for debt funds.

As the AUM grows the TER (Total expense ratio) is bound to be reduced as per below.

Source: Moneycontrol.com

The advantage of this reduction in TER was manifold and lead to the following benefits

• Lower Costs: The reduction in expense ratios meant that investors had to pay less in fees and charges to invest in Mutual Funds. This directly increased the returns on their investments.
• Improved Returns: With lower expenses, a larger portion of the investment amount was working for the investors, potentially leading to better overall returns on their investments.
• Transparency: This move by SEBI made the Mutual Fund industry more transparent by ensuring that the fees and charges were reasonable and directly related to the management of the funds. This transparency allowed investors to make more informed decisions.

Like previous cases, the overall AUM saw an upward trajectory, and the total AUM rose to Rs 26.54 trillion by the end of 2019.

VII. 2020: Categorizing Mutual Funds

Imagine you’re buying a product, but this product is invisible; you can’t see it or touch it. In such cases, the labels and descriptions become incredibly important because they give you an idea of what you’re getting.

In the world of Mutual Funds, there were so many funds and for any new investor, it was quite a bit confusing. Some funds were mixing in riskier stuff with schemes that were supposed to be less risky, which was misleading for investors. As the Mutual Fund industry got bigger, SEBI, the regulator, felt it needed to bring some order to how these funds were labeled.

• Labeling of Funds → Better Understanding → Less Risk

SEBI defined terms like “large-cap,” “mid-cap,” and “small-cap” stocks so that when a fund said it invested in them, it had to mean it.

SEBI also wanted to improve the labeling. For instance, they said funds couldn’t use the word “opportunity” when they meant “risk,” especially for debt funds that took a gamble with credit quality. They changed “credit opportunity” funds to “credit risk” funds to be more honest about the risks involved. So, these were better labels that all of us could easily understand just by the names of these funds.

In 2020, SEBI grouped the Mutual Funds into thirty-six different categories, each with specific rules on what they could invest in.

For example, a “multi-cap” scheme had to invest in large, mid, and small-cap stocks with a minimum percentage in each category. They also limited each fund company to having only one scheme in each category to simplify things for investors.

In short, SEBI tried to make choosing Mutual Funds easier. They did this by cutting down on the number of categories, telling funds what they could put in each category, and making sure each company had only one scheme per category. This also helped the investors to understand each category’s risk and the type of stocks the funds would invest in.

The AUM at the end of 2020 was Rs 31.02 trillion.

• Introduction of Risk-o-Meter:

Though Mutual Funds are a good option for long-term investing, they have their share of risks. Until now SEBI had concentrated on reducing the commissions and removing the entry barriers. So as a next step, they have introduced something called the Risk-o-meter.

The risk-o-meter is like a visual indicator that shows you the level of risk linked to a specific Mutual Fund scheme. It usually has five levels: low, substantially low, moderate, moderately high, and high.

This handy tool gives investors a quick overview of how a Mutual Fund operates and the potential ups and downs connected to it.

• How is the risk calculated?

The risk-o-meter is updated monthly based on how the stock market is performing. The results are shared with investors through the portfolio disclosure on the AMC or fund house’s website, typically around ten days before the month ends.

In addition, AMCs have to share this information with the Association of Mutual Funds in India (AMFI) every month.

So, as an investor, we can use the risk-o-meter as one of the criteria when we are deciding which Mutual Fund scheme to go for. It acts as a guide, helping us assess the fund’s risk levels and see if they align with your risk tolerance.

• Why these regulations?

Now comes the big revelation as to why these regulations are needed for Mutual Funds.

But before that let us study another product of which all of us are very much aware and see the nuances of that product and compare it with Mutual Funds in certain aspects

VIII. Insurance Policy Regulations vs. Mutual Fund Regulations

Have you ever received any calls from agents persuading you to buy ULIP policies? The answer without any deliberation is a definite YES.

On the other hand, have you ever received a call from any agent, or anyone related to the Mutual Fund industry asking you to invest in Mutual Funds? Well, the answer is not zero, but when compared to the number of calls you would have received in ULIP are bare minimum. This is because there is no forced selling in Mutual Funds unlike in Insurance policies.

Have you ever found yourself with a ULIP, and then the same agent calls you again, promoting a different plan to convince you to invest in it by withdrawing the earlier invested ULIP? In some instances, this does happen.

Conversely, do Mutual Fund distributors typically advise you to abandon your existing investments and switch to an entirely new fund? In most cases, the answer is no.

• Agent Commissions – Insurance vs. Mutual Funds

This is the basic fundamental difference between the commissions of an insurance policy and a Mutual Fund.

When you buy an insurance policy, a substantial portion of your initial payment often goes toward commissions to the agent. It’s like purchasing a car but being asked to pay extra just to drive it. The agents get their commissions and move on. They come back again for new investments only with the sole purpose of earning commissions.

This practice reduces the actual amount of money invested, which isn’t in the best interest of investors.

• What makes Mutual Funds stand out from the other products?

Mutual Funds have extensive regulations when compared with the ULIPS.

Mutual Funds are a more cost-effective option for investors as they’ve done away with front-loading charges. Plus, Mutual Funds typically don’t have entry fees, and their exit fees are lower, especially if you’re investing for the short term. This means you can switch between funds if you realize you made the wrong choice initially.

ULIPs, on the other hand, still have those front-loading charges and a variety of fees, including entry and exit charges. Switching between ULIPs isn’t as straightforward, making Mutual Funds the more investor-friendly choice.

• ULIPs vs. Mutual Funds – Rewards and Categorization

Mutual Funds reward distributors based on performance as we discussed earlier, ensuring their interests are in sync with investors who seek portfolio growth.

In contrast, ULIPs generally lack performance-based incentives for distributors. So, they potentially result in differing priorities when it comes to sales and service as they are commission-centric.

Mutual Funds benefit from SEBI’s categorization rules, which standardize product categories and investment objectives, offering investors clarity about their investment choices. For instance, a large-cap fund from ICICI and a large-cap fund from SBI can be compared to each other since they have the same style of investing.

ULIPs lack standardized categorization because there are no common benchmarks to compare them to. This absence of a standardized framework can lead to confusion among investors when attempting to grasp the different natures and objectives of various ULIPs.

IX. Conclusion

In the grand scheme of things, Mutual Funds have become a win-win situation for all the stakeholders, the investors, the Mutual Fund distributors, and the financial industry as a whole. It’s an investment avenue where your financial well-being is prioritized over hidden fees and commissions.

It promotes trust, transparency, and responsible financial planning, ensuring that the sector continues to grow and thrive while providing investors with genuine opportunities to build their wealth.

So choose the right fund, keep investing for the long term and Mutual Funds will help you reap the benefits.

Happy investing!