Capital market disruption

Concluding the series the author says it is time the MF industry participated in the possibilities offered by the rapid advancement in technology

Following up on my earlier article on the coming disruption in the capital markets, here I will discuss a similar scenario for the mutual fund (MF) industry with or without changes in the capital markets. In many ways, the MF industry has responded to technological changes even less than the capital markets. In the capital markets, trading is now almost fully electronic, except for some pockets of resistance around the world. In general, the equity and debt markets have undergone deep operational changes as a result of technological changes.

On the other hand, the MF industry has remained operationally unchanged despite changes in the technological landscape. And while the process of investing in MFs has changed somewhat over the years, this has been primarily because an additional mode of investment and holding has become available; investing in MFs through stock exchanges and holding MF units in demat form.

The manner in which investors invest with MFs outside these additions has remained la­r­gely unchanged from the 1930s, as have most other MF operational processes. As with the capital markets, much of the institutional framework that supports these processes is now re­dundant.

In the traditional non-exchange format, when investors invest in a mutual fund, they typically submit their application or instructions to the registrar and transfer Agent (RTA), either online or offline. Even if an application is submitted directly to the asset management company (AMC), it is sent to the RTA for processing. The RTA then captures all pertinent application data related. Funds flow directly to the bank account designated by the AMC. In the case of offline applications, the RTA arranges to deposit the payment instrument in the pertinent bank account. With all banks offering cash management system facilities to MFs, these deposits can happen anywhere in the country.

It undertakes this activity through all working days and all applications received, subject to the acceptance criteria, are processed into units at the NAV declared at the end of the day. The units so created are then deposited to the virtual account maintained for each investor by each AMC.

The process for redemptions is similar, ex­cept for the absence of an incoming payment or payment instrument. Applications are still collected through the day and, subject to timing and holding period criteria, where applicable, processed into money at a price related to the NAV declared at the end of the day. Depending on the type of scheme, payments to investors are made either the next day or a few days later, typically through a direct transfer to the investor’s designated bank account.

This operation process is based on, and still suited to a time when capital markets operated in physical spaces where entry was restricted to only a small set of people. Typically, the price at which one bought or sold a stock was not available till the day’s trading had ended. As these prices were an important input for calculating the pertinent fund’s NAV, this lag in their availability dictated that NAVs could be declared only once every day. This, and not the availability of day-end prices for all holdings, is the real reason for the daily NAV model. As far as day-end prices are concerned, there is absolutely nothing that either differentiates them or makes them superior to those acquired at any point of time during the day.

After close to a century of technological cha­nge in the capital markets and payment syste­ms, it is time that these processes change as well.

Based on the available technology and information flow, with transaction prices and market prices available to participants virtually on a real-time basis, there is no reason why NAVs of MFs should not be declared on a close to real-time basis as well. Even if a lag is to be permitted for transmission of information and calculations, it is entirely conceivable that all MF schemes, both debt and equity, can declare NAVs after every 15 minutes with a lag of a couple of minutes at the maximum.

And with real time payment systems already in place, it is entirely conceivable that unit creation for purchases can also happen at the same interval based on funds being received in the AMC’s designated account. For sales as well, the applicable NAV can be the next one declared, though payment of proceeds may be dictated by the exchanges’ settlement cycles. If, as discussed in my earlier article on capital markets, the exchange settlements also move to real time, then the lag in depositing redemption proceeds may also reduce to a few minutes.

The possibilities that these changes present go beyond the obvious. On the obvious front, these changes will allow investors to enter and exit funds at intra-day levels, even for actively managed portfolio. But there are other exciting possibilities that emerge in pure accrual-based debt products like overnight funds. Here, if the accrual format changes from end-of-day to continuous as well, investors can invest in the morning and exit in the afternoon and accrue returns only for the hours they remained invested. As with all changes, the true possibilities emerge only once the change is made.

It is time that the MF industry emerges from the technological dark ages and participates in the possibilities offered by the rapid advancement in technology and communication technology. For an industry that prides itself on far-sightedness, it’s time to walk the talk. 

The author is an economist, capital markets expert and the former CEO of Essel Mutual Fund