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