Bailing out mutual funds

Like the breakup of UTI into two, risk-averse and high net worth investors require separate options

By Mohan Sule

Till July 2009, asset management companies charged an entry load, which was deducted from subscription, to meet selling expenses. Since the scrapping of this model on complaints of non-transparency, the regulator has been toying how to compensate distributors. Retail investors’ lukewarm response to online trading, despite listing of even open-ended schemes, too, seems to have spurred the rethinking. Conveniently sidestepped is the fact that Sebi has not done away with distributors’ commission. It has allowed AMCs to use up to 1% percentage point from the exit load for marketing costs. Besides, distributors can negotiate their fees directly with subscribers. Even before this scheme’s efficacy could be tested, new fund offers dried up as AMCs and distributors decided investors would be reluctant to pay an upfront fee. Embedded in this reservation is the acknowledgement that even the previous method of payment would not have got investors’ sanction had they been aware of the subtractions, which varied across AMCs and schemes. As returns cannot be guaranteed, the basic selling point of AMCs has been that mutual funds offer a safer route than investing directly in the stock market as experts manage the money. The experience of investors, however, has been different. Very few schemes outperform the market or give positive returns during a downturn. Even the protection of capital is uncertain. Not surprisingly, there is resistance to online transactions despite the brokerage outgo being much less than the entry load-levied by AMCs earlier.

What can be done to break the impasse? Lessons can be drawn from the bailout of the then biggest mutual fund in the country in 2003. Sales of UTI’s flagship open-ended scheme, US 64, lagged behind redemption during the market turmoil triggered by the flight of capital from South East Asia in 1997. Due to asset-liability mismatch, the government-sponsored fund was unable to meet its promises. Subsequently, the Central government decided to repeal the UTI Act, 1963, splitting UTI into two companies. UTI-I comprised US-64 and assured return schemes. NAV-based schemes were handed over to UTI-II, which has evolved into the present UTI Asset Management Company. The government issued securities to UTI-II to buy out the risky assets of
UTI-I and invest in fixed-income instruments consistent with its commitment of assured returns. US-64 investors opting out were guaranteed repurchase at Rs 12 per unit. Those who wished to continue were offered tax-free dividends and exemption from capital gain tax. After the market resumed its bullish phase, UTI was able to repay the government’s capital infusion and UTI I was extinguished on redemption of all the schemes. What are the conclusions? The financial services industry cannot offer a universal product catering to all segments of the market. The mutual fund industry has to change track to attract the risk-averse investors. In the initial phase, most of the AMCs were mainly set up by banks unable to grow their balance sheets due to restrictions on lending and borrowing and industrial houses viewing mutual funds as a transition to setting up banks. There is now a need to bifurcate the industry.

One category would be made up of the present dispensation, preferring new launches to grow the business. These funds can be mandated to invest only in the top 200 companies by market capitalisation. The returns on these schemes would be not very exciting but adequate for the small investors whose priority is capital protection. These AMCs can charge a flat fee. The second category would comprise funds floated by talented money managers who would attract investors on the basis of their performance. Right now, the mutual fund industry uses the sponsor’s brand to lure investors rather than the track record of its fund managers. Naturally, the capital requirement to enter this space would be smaller than Rs 10 crore, say, between Rs 2 crore to Rs 5 crore. These funds would take exposure to stocks excluding the top 200. Mid and small caps offer the highest growth opportunities but at the same time are volatile. By linking marketing and AMC fees to performance, the funds can attract investors with risk appetite. Presently high net worth investors prefer portfolio management schemes. These are loosely regulated and could be encouraged to convert themselves into mutual funds. The survival of UTI was considered important for the government to pump in Rs 18600 crore between 1998 to 2003. Similarly, a drastic restructuring of the mutual fund industry is crucial to gain investor confidence. The problem is not the mode of trading or commission but performance, which will get sorted out once investors become aware of the risk-return options available.

Mohan Sule

Silver linings

Companies’ efforts to shed fat and collaborate with competitors should be supplemented by relaxation in regulations

By Mohan Sule

The downsides of an economic slowdown are erosion in wealth of investors and squeeze in the margin of companies. Yet a downturn can have its upsides. The correction provides an opportunity to investors who had booked profit on signs of heating or those who were rather late in spotting winners for stock-picking. For companies, it is time to sit back and assess their expansion and diversification. How much of the quest for growth has proved counterproductive by unnecessary dilution of equity or burdening the balance sheet with debt? The lackluster market and high interest rates are triggers for spring cleaning by hiving off emerging businesses and subsidiaries without strategic synergy so as not to drag down the parent. Recently, Bharti Enterprise, the holding company of Bharti Airtel, sold off its entire 74% stake in the insurance joint venture with Axa of France to Reliance Industries. Earlier, Piramal Healthcare divested its formulations business to Abbott Laboratories of the US. The cash so obtained can be either used to reduce debt, for buybacks to improve valuation or ploughed back into the core business. Slump sales become fashionable. The most surprising exit was the decision of the promoters of Ranbaxy Laboratories to vacate in favour of Daiichi Sankyo of Japan mid 2008 as the bull-run was winding down. The process implies lack of sustaining power in face of changing regulatory environment.

It is during sluggish stock movements that the absence of a vibrant mergers and acquisitions market, mainly due to the controlling stake of Indian promoters, is sorely felt. Imagine the benefits to investors of a hostile raid on a company whose returns on assets are mediocre. Investors in telecom stocks would have been out of their misery if a foreign player were to mop up the shares of the 2G scam-tainted companies. In fact, a slowdown also provides a window to promoters to consolidate their holding through creeping acquisitions. In the short term, the move provides support for the stock but, in the long term, makes it illiquid and volatile. The government seems to have realised the importance of free float for efficient price discovery. A minimum 25% public holding is required to stay listed. Going further, the threshold level should be raised to 40% and eventually 51%. This would encourage more foreign portfolio investment and perk up the interest of retail investors. Hard times also see increasing collaborations between companies under pressure from competition. This is gaining traction in the tech sector across countries. Microsoft is working with Nokia to develop the operating system of the latter’s smart phones and tablets. Google has tied up with a host of competitors of Apple including Samsung for its Android operating system. Chip makers, too, are signing up with specific handset makers. In India, promoters of late are realising the benefit of such arrangements. Telecom companies are sharing tower infrastructure.

A year ago, the promoters of East India Hotels invited Mukesh Ambani to thwart ITC’s ambitions.Companies are also leaning to distribute functions that support their core business to others, a phenomenon whose prominent beneficiary has been the tech sector. Even assembly-line functions are now being outsourced for specialisation and efficiency, particularly in the automobile and pharmaceutical sectors. Companies also become innovative to cut costs. The FMCG sector has introduced the concept of trimming package size without sacrificing price to maintain market share while passing on the rising cost of inputs. Some go shopping for distressed assets. Tata Motors swooped on Jaguar-Land Rover early 2008 and is now reaping the dividend of the turnaround. Not only companies, even governments, regulators and central banks can contribute to revive the economy as seen post the Lehman Brothers’ collapse when central banks and governments acted in coordination to inject liquidity and introduce fiscal stimulus packages. Another way is to relax well meaning but stiff regulatory norms to keep the interest of issuers and investors alive in the market. The NDA government encouraged tech companies to list only 10% of equity and appointed a divestment minister to revive the primary market. Sebi recently increased the limit of retail participation in IPOs and FPOs from Rs 1 lakh to Rs 2 lakh. Now the UPA government should temporarily scale back the short-term capital gain tax to 10% from 15% to boost trading volumes. An aggressive divestment program by lining up profit-making PSUs, rather than those in the red, at a steep discount to the market price could be a neat counterbalance to the UPA government’s rural tilt, which has provided fuel for growth as well as for inflation.

Mohan Sule