Regulation of mutual funds

Morley and Curtis wrote a very interesting paper earlier this month on the regulation of mutual funds. Their fundamental point is that the open-end mutual fund presents governance problems of a completely different nature from that of normal companies.

Unit holders do not sell their shares in the market, they redeem them from the issuing funds for cash. This uniquely effective form of exit almost completely eliminates the role of voice – investors have no incentives to use voting or any other form of activism.

Morley and Curtis advocate product-style regulation of mutual funds. As I understand this, we must treat unit holders as customers and not as owners of the fund. They also advocate regulations that make it easier for investors to exercise exit rights effectively.

I think this insight is fundamentally correct. In the US context where mutual funds are organized as companies with unit holders as shareholders, this implies a huge change in the regulatory framework.

In the Indian context, mutual funds are organized as trusts and investors are legally the beneficiaries of the trust rather than the owners. Indian regulation already uses exit as a regulatory device. Whenever there is any change in the fundamental characteristics of a fund or in the ownership of the asset manager, the fund is required to provide an opportunity to investors to exit at net asset value without any exit load.

However, the trust structure creates another set of confusing and meaningless legal requirements. The governance is divided between the board of the asset management company and the trustees of the trust. This creates a duplication of functions and regulators might hope that if one of them fails, the other would still operate.

It is however more likely that each level might rely on the other to do the really serious work. The job might be done less effectively than if the locus of regulation is made clearer. There is probably merit in creating a brain-dead trust structure and making the board of the asset management company the primary focus of regulation. This is more consistent with the idea of unit holders as customers.

One implication that Morley and Curtis do not draw from their analysis is that closed-end funds are dramatically different from open-end funds and require totally different regulatory structures. Regulations in most countries tend to regard these two types of funds as minor variants of each other and therefore apply similar regulatory regimes to both. If Morley and Curtis are right, we must treat open-end unit holders as customers and closed-end unit holders as owners.

The governance of a closed-end fund should more closely mimic that of a normal corporation. Regulations should permit the unit holders of a closed-end fund to easily throw out the asset manager or even to wind up the fund. The trust structure in India does not give unit holders formal ownership rights – explicit regulations are required to vest them with such rights.

Posted at 7:58 pm IST on Wed, 24 Feb 2010         permanent link

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