Posts this month
A blog on financial markets and their regulation
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
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.