Structure Of Mutual Funds

SEBI’s regulations specify how the sector is to be structured, right from the institutions that keep it running to the entry requirements for these players, as well as their roles and responsibilities. If people feel relaxed about their mutual fund investments, it is largely because of the regulatory safeguards.

For a mutual fund investor, it helps to understand the different components of the sector. As mentioned, market regulator SEBI forms regulations which govern the functioning of mutual funds. These pertain to disclosure requirements, mutual fund classifications, and investor relations, among other things. But SEBI is only one player out of many, and this article will introduce you to the many institutions that make up the world of mutual funds.

How Mutual Funds Are Structured

As per SEBI’s regulations, every mutual fund has a three-tiered structure. And fund houses have to disclose the details in their scheme-related document. Let’s focus on the three components of this structure.

Tier 1: Fund Sponsor

A sponsor or a guarantor is an individual or company that launches the mutual fund. The sponsor sets up the mutual fund as a public trust under the Indian Trust Act, 1882. In simple terms, a trust is an entity created to transfer property from one person to another. In case of a mutual fund, the fund is set up to hold assets on behalf of its investors. But it is not a charitable trust. The sponsor creates the fund with the express intention of earning money.

However, not everyone can be a sponsor. The SEBI regulations specify certain entry conditions for mutual fund sponsors. As per the regulations, a sponsor must meet the following criteria:

• The sponsor must have experience in the financial services industry for at least five years.
• The sponsor must have a positive net worth. Having a positive net worth means that the assets of the sponsor exceed their liabilities.
• The net worth of the sponsor must exceed the capital contribution put up by the asset management company (AMC).
• The sponsor must show profits in the previous three years (including the last financial year).
• The sponsor must have a share of 40% or above in the AMC.

A fund sponsor is similar to the promoter of a company.

Tier 2: Trust And Trustees

The sponsor generally appoints a number of trustees for the mutual fund. The sponsor also creates a trust in favour of the trustees through a trust deed. These trustees are now tasked with managing the trust. This means:

• They are responsible for the fund’s performance.
• They are answerable and accountable to the investors.
• They are the representatives of the fund to the authorities.
• They must ensure that the fund complies with the SEBI regulations.
• Once every six months, they must report to SEBI about the funds’ activities.
• They must appoint competent fund managers to run the fund.
• They must set up the mutual fund office and hire a back-office team.
• They must appoint a compliance officer or ombudsman to deal with investor complaints and feedback.
• If the AMC wants to launch a new fund, they need approval from the trustees.

Some laws applicable to the trustees are the Indian Trust Act, the Companies Act, and the SEBI Mutual Fund Regulations.

The structure of mutual funds has safeguards to ensure multiple levels of accountability. The trustees function similar to the Board of Directors of a company. And SEBI has some rules pertaining to who can be appointed as a trustee:

• At least two-thirds of the trustees must be independent and not related to the sponsor in any capacity.
• There must be a Board of Trustees with at least four independent trustees.

Tier 3: Asset Management Company (AMC)

The AMC is the fund manager or investment manager, and it charges a fee for its services. The AMC is responsible for the day-to-day management of the fund. Here’s a look at its various functions:

• It can launch new schemes and close old schemes.
• It can make decisions about the total expense ratio (TER), the assets a particular scheme will hold, and much more.
• It is directly responsible for the fund’s performance. It is the fund manager’s responsibility to ensure the fund provides maximum returns to the investors.
• It appoints auditors, the registrar and share transfer agents, and a custodian, as well as negotiates their compensation.
• It presents accounts to the trustees.
• The onus of investor education also lies heavily with the AMC.

To prevent the misuse of investor funds, SEBI has strict regulations about the business activities of an AMC. Here are some of them:

• An AMC may not provide portfolio management services or general management and consultative services to other mutual funds.
• It may not invest in its own mutual fund unless this is disclosed in the offer document.
• It cannot become a trustee for any other mutual fund.

Other Institutions In The Mutual Fund Ecosystem

Apart from the sponsor, the trustees, and the AMC, some other institutions are also a part of the mutual fund ecosystem. These entities work together with the AMC to ensure the smooth functioning of mutual funds.

Custodian

Even though the AMC purchases assets, it does not physically hold them. These assets are held by the custodian. Take a look at some of the primary functions of a custodian:

• They are responsible for the safekeeping of records for the AMC.
• They manage the delivery and transfer of securities.
• They carry out recordkeeping and back-office processing for the mutual fund.
• In case of asset purchases, the custodian ensures the funds are paid out to the seller.
• They manage the dividends and interest earnings from fixed-income instruments for mutual funds.
• Whenever a company notifies a bonus issue or a rights issue, the custodian ensures that the AMC gets all the benefits that it is supposed to.
• They maintain a list of assets purchased and sold by the mutual fund. Thus, the custodian monitors pay-outs received and gains accrued. However, the custodian does not make any recommendations to the AMC. They also cannot initiate any buy or sell calls on behalf of the AMC. Their functions are limited to back-office work.

Some international funds make investments overseas. In such cases, the custodian plays a vital role in tracking communications that the mutual fund receives from the companies it has invested in.

Registrar and Transfer Agents (RTA)

The RTA forms a link between the AMC and individual investors. In case of any modifications in the folio number or information, investors have to reach out to the RTA. Let’s take a closer look at the RTA’s main functions:

• It maintains exhaustive records of the investors, including folio, number of units, scheme details, history of transactions, contact details of the investor, KYC of the investor, and so on.
• It sends account statements and periodic reports to the investors, as well as intimates them in case of dividend declaration.
• It maintains the list of investors including additions and deletions on each day.

The AMC sometimes provides RTA services in-house, but at other times the functions are outsourced. Many mutual funds prefer to outsource RTA functions since it is not their core competency. CAMS and Karvy are two of India’s largest RTAs for mutual funds.

Auditor

The auditor checks the records of the AMC to ensure funds are being used for the reason they have been collected. Auditors certify that there is no evidence of fraud in the books.

The AMC is free to decide who to appoint as an auditor and decide on the compensation for the service. But it must follow all the rules regarding the appointment of auditors, as well as publish the auditor’s report and carry out other tasks detailed in the Companies Act.

Broker

Brokers are institutions and individuals authorised by SEBI and holding a license to operate trading accounts. They form the link between investors and the stock market. AMCs need to operate through brokers to carry out trades. Many brokers also issue research reports which AMCs use as a part of their due diligence.

Agents

Agents and distributors are an important link between the retail investor and the mutual fund. Agents recommend mutual funds to their clients and ensure the purchase transaction goes through. In return, the mutual fund pays the agents a commission.

Summing up

As you can see, the structure of mutual funds is very clearly defined. There are a number of checks and balances to ensure the safety of investors’ money. But as an investor, you need to do the due diligence too. Keep in mind that not all mutual fund schemes are created equal and invest accordingly. When shopping for a mutual fund scheme, study its past performance, review its fees and charges, and check the track record of its fund manager. If you need help, open an account with a reliable broker like Kotak Securities that provides educational resources for investors of all levels. Mutual fund investment is an effective way to build your wealth, but only if you make informed decisions.