Predictable problem

0The report that a mutual fund has been illegally switching money invested with it by a provident fund into equities, raises several concerns.

The most obvious one, of course, is to check whether this is an isolated instance of a fund manager overstepping his brief or whether the practice is widespread.

The Securities and Exchange Board of India has started investigating; the market regulator as well as the Association of Mutual Funds in India (AMFI) should widen the scope of the inquiry to verify whether a monitoring mechanism is in place to ensure that mutual funds abide by the rules. The bigger concern, however, is whether the rules are being broken with the full knowledge of the PF authorities.

There are two reasons for such a suspicion. One is the keen competition among mutual funds, which has resulted in fund managers offering a host of incentives to large investors. Allowing large corporate investors to invest at the previous day's net asset value and allowing late trades are practices that have been detected not only in India but in the United States as well.

Cosy relationships between large investors and fund managers are not unknown, and kickbacks are not uncommon. Given the nexus between unscrupulous fund managers and some corporate houses, there is room for suspicion that the same "incentives" may be offered to provident fund trustees as well.

The second reason why provident fund trustees may turn a blind eye to, and indeed encourage fund managers to invest in equities, is because of the high returns (currently 9.5 per cent) that provident funds have to give to their investors.

This rate of return is the result of administrative diktat by the labour ministry and is far removed from actual returns currently available on debt instruments, which is where provident funds have to invest. This need to generate high returns obviously puts pressure on PF trustees and managers to cut a few corners.

The temptation increases when fund managers offer unofficial "guaranteed returns" for large investments. It's not only by investing in equities that provident funds are exposing themselves to unnecessary risks "" several reports have suggested that, with the majority of the prescribed investments yielding 6 to 8 per cent per annum, PF managers are forced to seek out higher yield instruments such as state government guaranteed bonds, which, however, also carry a much higher risk. Simply put, the necessity to generate high returns automatically leads to the assumption of higher risk.

Under these circumstances, the way forward is crystal clear. On the one hand, the monitoring mechanism must be tightened. The Home Trade scam had exposed the many gaping holes in the regulation of provident funds, and it needs to be ensured that those holes no longer exist.

The ongoing reforms in the mutual fund industry must continue, and it must be ensured that "guaranteed returns" are a thing of the past. The Employees Provident Fund Organisation (EPFO) has recently instituted several changes in its business processes, and has improved services for members and ensured faster access to their savings.

However, in the face of falling interest rates in the economy, the EPFO will also need to review its investment regulations. On the other hand, and more importantly, the incident reinforces the demand for market-related rates of interest on provident funds, and indeed for doing away with all administered (read politically determined) rates.