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Ethics in Mutual Fund Management – Investor Interest First

Introduction

Mutual funds handle ₹50+ lakh crore of public money. Ethics isn't optional—it's mandatory. SEBI and AMFI enforce strict codes of conduct to protect investors from malpractices.

The Fiduciary Principle

Fiduciary Duty: AMC and fund managers must act in the best interest of investors, not themselves.

What it means:

  • Investor interest comes first (before AMC's profit)
  • No conflict of interest allowed
  • Complete transparency required

Legal Basis: Trust law (fund held in trust for investors)

Key Ethical Principles

1. Investor Interest First

Fund managers must NOT:

  • Buy stocks they personally benefit from
  • Favor certain investors over others
  • Take decisions that benefit AMC but harm investors

Example of Violation:

  • Fund manager owns shares of Company X
  • Buys Company X shares for the fund (drives up price)
  • His personal shares also rise → Conflict of interest

2. Fair Treatment (No Discrimination)

All investors treated equally:

  • Same NAV for everyone (on same day)
  • No preferential allotment
  • Same redemption rules

Prohibited:

  • Giving early NAV information to select investors
  • Processing redemptions faster for VIPs

3. Transparency & Disclosure

Mandatory Disclosures:

  • Daily NAV publication (by 9 PM)
  • Monthly portfolio (top 10 holdings)
  • Quarterly factsheet (full portfolio)
  • Annual report to all unitholders
  • Expense ratio disclosed

No Hidden Charges: All fees must be disclosed upfront

Common Ethical Violations (Prohibited)

1. Front-Running

What: Fund manager buys a stock personally, then uses fund money to buy large quantity of same stock (drives up price)

Example:

  • Manager buys 1,000 shares of ABC Ltd @ ₹100 (personal account)
  • Next day, uses MF's ₹50 Cr to buy 10 lakh shares @ ₹110
  • Price rises to ₹120
  • Manager sells personal shares → Illegal profit

Punishment: SEBI can ban manager, impose penalty on AMC

2. Churning

What: Excessive buying/selling of stocks to generate brokerage (AMC earning through affiliated broker)

Problem:

  • Increases transaction costs
  • Reduces investor returns
  • Benefits broker (who may be AMC's subsidiary)

Example:

  • Fund buys ₹10 Cr of Stock A
  • Sells it after 1 week
  • Buys again after 2 days
  • 20 transactions in a month (unnecessary)
  • Brokerage: ₹50 lakh (paid to broker)

Protection: SEBI monitors turnover ratio (should be logical)

3. Mis-Selling

What: Distributors misleading investors to earn commission

Examples:

  • Selling equity fund to a 70-year-old (needs stability, not risk)
  • Promising guaranteed returns (market-linked products have no guarantee)
  • Hiding exit load and lock-in period (ELSS)

AMFI's Code: "Suitability first, commission second"

4. Insider Trading

What: Using confidential information to trade

Example:

  • Fund manager knows Company X will announce bad results tomorrow
  • Sells fund's holding before announcement
  • Illegal (insider information)

Allowed: Only public information can be used for decisions

Regulatory Framework for Ethics

A. SEBI (Mutual Fund) Regulations

Key Rules:

  1. Trustees must be independent (2/3rd non-sponsor)
  2. AMC cannot engage in insider trading
  3. Fund manager personal trades must be disclosed
  4. Scheme names must reflect actual investment strategy (no misleading names)

B. AMFI Code of Conduct

For AMCs:

  • Maintain arm's length distance from distributors
  • No quid pro quo arrangements
  • Publish all disclosures on time

For Distributors:

  • Know Your Customer (KYC) mandatory
  • Suitability assessment before recommendation
  • No false promises
  • Disclose commissions

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Internal Controls at AMC

1. Compliance Officer

Role:

  • Monitor all trades
  • Ensure SEBI regulations followed
  • Report violations to trustees
  • Quarterly compliance certificate to SEBI

2. Chinese Wall

Concept: Information barrier between departments

Example:

  • Fund Management Team (makes investment decisions)
  • Broking Team (executes trades)
  • Marketing Team (sells schemes)

Rule: No sharing of confidential portfolio information

3. Risk Management Committee

Monitors:

  • Sector concentration (not > 25% in one sector)
  • Single stock limit (not > 10% in one stock)
  • Derivative usage limits

Comparison: Ethical vs Unethical Practices

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Case Study: SEBI Action on Mis-Selling (2018)

Incident: Major bank's employees mis-sold equity funds to customers who wanted FDs

Malpractice:

  • Promised "FD-like safety"
  • Hid market risk
  • Pushed equity funds for higher commission

SEBI Action:

  • Imposed ₹5 Cr penalty on bank
  • Mandated investor compensation
  • Stricter KYC norms enforced

Learning: Suitability > Commission

Investor Protection Measures

  1. SCORES Portal (SEBI Complaints Redress System)

    • Online complaint filing
    • 30-day resolution mandate

  2. Ombudsman Scheme

    • Free arbitration for investor grievances
    • Binding on AMC (if upheld)

  3. Investor Education

    • SEBI's "Mutual Fund Sahi Hai" campaign
    • Awareness about risks, returns, costs

Exam Notes: Writing the Answer

Question: "Explain the role of ethics in mutual fund management." (10 Marks)

Answering Structure:

  1. Fiduciary Duty: AMC holds investor money in trust
  2. Key Principles: Investor interest first, fair treatment, transparency
  3. Prohibited Practices: Front-running, churning, mis-selling, insider trading
  4. Regulations: SEBI MF Regulations, AMFI Code of Conduct
  5. Internal Controls: Compliance officer, Chinese Wall, Risk Committee
  6. Conclusion: "Ethics ensures trust and long-term sustainability of MF industry"

Quiz Time! 🎯

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