SEBI Introduces New Rule to Curb NFO Mis-Selling and Reduce Portfolio Churn

The Securities and Exchange Board of India (SEBI) has introduced new regulations to curb unnecessary portfolio churn by distributors seeking higher commissions, particularly in light of increased asset mobilization through New Fund Offers (NFOs).

As per the updated guidelines, distributors will no longer earn higher commissions for transferring investments from existing schemes to NFOs. SEBI clarified this measure in a statement following its Board meeting, stating, "For switch transactions, the distributor shall be entitled to the lower of the two commissions offered under the respective schemes involved in the switch."

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Mutual Funds (MFs) allow investors to transfer funds directly between schemes without redeeming the investments first. This switch mechanism has been a key channel for mis-selling practices, according to Feroze Azeez, Deputy CEO of Anand Rathi Wealth. "This measure addresses cases where distributors promote switching to NFOs purely to earn higher commissions, a trend commonly seen in regular plans," he noted.

Experts believe that limiting the rule to switch transactions will help reduce mis-selling. G Pradeepkumar, a former senior MF executive, explained that distributors favor switches over redemptions since investors might reconsider investing after receiving the funds in their bank accounts.

While some Asset Management Companies (AMCs) had already applied this rule to equity scheme switches, the new regulation expands it to include transactions from debt to equity funds. Mohit Gang, Co-Founder and CEO of Moneyfront, noted, "This change now encompasses switches from debt funds to equity funds as well."

Additionally, SEBI has mandated that NFO proceeds be deployed within a 30-day timeframe. This requirement aims to ensure AMCs launch schemes that align with market conditions and only raise funds they can invest promptly. As Azeez remarked, "This timeline ensures that AMCs collect money with investor interests in mind, avoiding delays in fund deployment."

Introduction of PaRRVA for Risk-Return Validation

In a related effort to enhance transparency, SEBI has introduced the “Past Risk and Return Verification Agency” (PaRRVA). This agency will validate claims made by investment advisors, research analysts, and algorithmic trading platforms regarding their performance metrics.

Under the new framework, any claims like "top-performing," "best during volatility," or similar assertions must undergo validation by PaRRVA. A credit rating agency will perform the verification, while a stock exchange will act as the data center. Sources revealed that the National Stock Exchange (NSE) has already established an entity for this purpose, although the final choice of exchange and credit rating agency is pending.

Industry players liken PaRRVA validation to an ISI mark for investment claims, ensuring accuracy and building investor trust. However, challenges remain, such as establishing a reliable data framework and determining the costs involved. A research firm executive commented, "While this will increase operational costs for entities, it will significantly improve trust within the ecosystem."

SEBI initially proposed a performance validation agency in 2023 and has since worked on refining the concept. A pilot phase will test PaRRVA’s operations over two months, during which the agency will gather feedback and enhance its processes before transitioning to full operations. Although using PaRRVA is optional, entities opting out will be barred from making performance-related claims.

This initiative follows SEBI’s 2022 directive prohibiting stock brokers from associating with algo platforms that make unverifiable performance claims. The validation agency is expected to address similar issues, particularly concerning false claims on social media aimed at luring investors.