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Journalism of Courage
The mutual fund industry last week was in a tizzy. A nasty rumour did the rounds of fund houses. The rumour had it that the FM has removed the tax (ELSS) benefit to mutual funds in the final notification of the Section 80 C products. If this story was not bad enough, a few days later the markets regulator M Damodaran, at the CII Mutual Fund Summit in Mumbai, gave a severe tongue lashing to the whole industry talking about poor communication to the retail investors, rebating, churning and assets under management (AUM) targeting.
The backdrop to the rumour and the public scolding is a meeting that the FM is believed to have had with the regulators in which he asked why the tax breaks to funds should not be taken away, given that the mutual funds in India remain a vehicle for the institutional and high net worth individuals. The Minister was also upset at the low net flows into the mutual fund schemes, despite a record increase in gross collections, pointing to a huge churn in the market (see box).
The problems that the regulators have mentioned have been articulated often enough. We look at some solutions that the industry and the regulators could consider to get the industry back on track. Mutual funds, internationally, are the safe way to take the upside that equity can give to a retail portfolio. It will be a pity if the sharp practices in the Indian industry will put off the very investor the instruments was designed to benefit.
Problem: AUM targeting
Targets in mutual funds are not about returns, but about AUM. Since the income of a mutual fund is a percentage of the AUM, irrespective of returns, the higher the AUM, the greater the income of the fund. After a certain level, the costs remain the same and every Rs 100 crore of AUM increase directly increases profits by about Rs 1 to 1.5 crore. Hence the fixation with increasing AUMs. Since companies choose funds (to park their short term money) on the basis of size, the larger funds (in AUM terms) get a proportionality larger chunk of the corporate money. Some fund houses attract money by paying a percentage to the distributor or company for the last four days of every month, which is when the AUMs are counted. The industry association Amfi has issued an ‘advisory’ to the 29 AMCs asking them to disclose their the daily average over the month. This has been taken up seriously by only 12 funds and not the rest.
Solution: Sebi should make it mandatory to disclosure AUMs daily or the average monthly AUM.
Problem: Miscommunication and inability to explain products properly.
Fund houses are supposed to print a Key Information Memorandum (KIM) that is mandatory to be distributed with a mutual fund application form. Some funds print the KIM like an IPO form, others print a booklet that has a form attached to it. Most investors do not read it either because the print is too small or they are unable to decode the information. It then falls on the agent to communicate the basics of a scheme. Agents maximise commissions and sell what earns them the maximum income and not what is good for the investor.
Solution: Better disclosures. Highlight the five to ten material attributes of a mutual fund scheme in point size that is easily readable.
Problem: Mis-selling and churning.
The mutual fund agent is the weakest link in the mutual fund industry today. Just passing a qualifying exam allows the agent to sell what he likes without any responsibility. The agents maximise their commissions and not the interest of the investor. Not only do they sell ‘inappropriate’ (for example, a tech fund to a risk-averse retired investor) products, but also encourage investors to ‘churn’ (frequent buying and selling that earns distributors commission) their portfolios frequently. If a distributor is able to churn a Rs 25 lakh portfolio four times, he gets to make Rs 2.5 lakh out of one client.
Solution: Need to get the distributors under the regulatory scanner. Disclosure and ownership of recommendation clauses in the regulation are needed.
Problem: IPO games.
Since investors believe that a mutual fund IPO works the same way as a stock IPO (premium is build into the price over time and getting in at Rs 10 is better than getting in at Rs 50), the industry is doing everything to take advantage of this misconception. Most major fund houses have come out with several ‘new’ schemes in the last eight months to take advantage of the bull run, while the basic nature of the scheme does not change. Fund houses like new issues because they are easier to sell and they get their marketing costs back (Sebi rules allow fund houses to recover 6 per cent of the funds collected as new issue expenses from the investors) and the agents push them since they earn a higher commission of these than older schemes.
Solution: More innovations. Like the variable cost fund. Like the split capital fund. The industry is already dividing itself to the fund houses that gather the most AUM and those that give consistent performance and innovative products.
New ideas in Fundsville
New things can happen in funds in at least four ways: a new fund house launches its first scheme, a new category of assets comes into the fund market, an existing fund house launches a truly innovative scheme or there is some change in the cost structure that benefits the investor. The last six months have seen three of the above happening. The fourth – a new asset class – will happen with the launch of gold funds later this year. Fidelity, a new entrant to fund management in India, is working on the concept of just one equity scheme in its portfolio, unlike the prevalent practice of launching several schemes that basically do the same thing. In the innovation space, not surprisingly, the true innovation in the mutual funds is coming not from the AUM gathering market leaders, but the smaller and newer fund houses. Sahara Mutual fund last week launched its new equity scheme Wealth Plus. Costs in this scheme are related to performance. This scheme will only charge the allowed management fee of 1 per cent, if the fund delivers positive return and also outperforms its benchmark, the S&P CNX 500. Even if the fund beats the benchmark but delivers negative returns, the fund house would charge only half the maximum permissible management fee.
Another first for India is from Benchmark Mutual Fund, known for its Exchange Traded Funds (a low cost way to do smart indexing) with its Split Capital Fund. This is an attempt to split the risk according to risk appetite amongst investors. There is a class of equity investors who want some of the growth that equity gives without putting their principal at risk. For such investors Class A of this three year closed end scheme will work. For those who are willing to take a higher risk, Class B will work.
