Of Bollywood, Mutual Funds, and INR 100 Bn AUM

Some of my friends are Bollywood aficionados. They are informed of not only which movies are being screened, but also their box office numbers. As a result, even I have become familiarised with terms such as “the 100 crore club”. For the uninitiated, apparently box office collections of at least INR 100 crores (INR 1 billion) is a parameter for a movie to be considered a success.

Oddly, a somewhat similar scenario is brewing in mutual funds. Thanks to a combination of steady inflows and rising markets, several equity-oriented funds have an asset size exceeding the INR 10,000 crores (INR 100 billion) mark.

However unlike box office numbers, growing assets of mutual funds are giving some investors and distributors sleepless nights.

Is the evaluation parameter apt?

An evaluation parameter must be based on sound logic for it to be relevant.

Let’s consider the 100 crores mark for movies. Say movie “ABC” costs INR 30 crores to make, and its box office collection is INR 70 crores. Compare this with movie “XYZ”, which costs INR 90 crores to make, and clocks proceeds of INR 110 crores.

Now if grossing INR 100 crores is the benchmark of success, then “XYZ” has succeeded, while “ABC” is a failure. However, if cost is considered, it is apparent that “ABC” is more profitable (hence, more successful) versus “XYZ”.

Clearly, selecting an apt benchmark is vital. This principle holds good in the case of mutual funds too.

Does size matter?

Asset size can matter because a mutual fund operates within the restraints of liquidity, market cap, and availability (listed stocks). That said, jumping to a conclusion such as “large asset size=bad, and small asset size=good” would be naive.

Let’s consider small and mid-cap funds. Here, a large asset size can pose challenges in the form of market-impact cost, the opportunity cost of having to spread trades out over longer periods, and liquidity management.

Conversely, a large asset size offers economies of scale. In India, regulations ensure that the expenses charged to a fund reduce, as size grows. In categories such as liquid funds wherein margins are wafer thin, a competitive cost structure aids the investor’s cause in no small measure.

Furthermore, in certain segments of debt markets (such as government securities), the minimum lot size is substantial. As a result, a small-sized fund may not be able to invest in it, thereby depriving investors of a wholesome investment experience.

Simply put, no blanket rule can be applied. The relevance of a mutual fund’s asset size depends on the individual specifics of each case.

Is INR 100 billion a sacrosanct number?

It’s hard to figure out why there is so much focus on the asset size of INR 10,000 crores for equity funds. To begin with, that number isn’t backed by any reasoning. Furthermore, as we learned from the case of the “100 crore club”, a number in isolation means little.

Let’s take the case of a large-cap equity fund with assets of INR 17,000 crores (INR 170 billion). In absolute terms, one might be inclined to believe that the fund’s size is substantial.

However, the size amounts to roughly 0.36% of the S&P BSE 200’s (an apt benchmark index) free-float market cap. In other words, the fund isn't really large.

Conversely, a small-cap fund with a size of INR 5,000 crores (substantially lower than the "hallowed" INR 10,000 crores) could struggle to freely invest without hampering performance.

What investors must do

Instead of focusing on the asset size in isolation, investors would do well focus on the consequences of a growing size.

To begin with, not every portfolio manager is skilled enough to manage a large-sized fund; neither is every investment style adaptable to a large fund.

Look for signs of stress—the manager’s investment style changes sharply, the portfolio acquires a tail which doesn’t add value, the long-term showing consistently falters.

A growing asset size could result in the fund’s character undergoing a fundamental change. For instance, a fund that made its mark as a small/mid-cap fund could end up becoming a large-cap fund.

In such a scenario, investors must evaluate if the fund yet merits a place in their portfolios. If the intention was to invest in the small/mid-cap segment, then corrective steps are in order.

Finally, in cases wherein despite a growth in asset size, there is no discernible change either in the portfolio manager’s investment style and the fund’s character, investors should ignore all the noise and stay invested.

Much ado about 'no entry load'

All right. So, the Securities and Exchange Board of India (SEBI) has decided that mutual funds will no longer be permitted to charge an entry load. And all hell has broken loose! Newspapers are carrying articles with comments from 'experts' and 'senior officials' at fund houses running down the move; a lot of emphasis is being laid on how this step will hurt the mutual fund industry. But is that correct? Can a step that is evidently pro-investor be detrimental to the industry?

Let's take a look at what SEBI has proposed. Following is an extract from a press release posted on SEBI's website:

"There shall be no entry load for the schemes, existing or new, of a Mutual Fund. The upfront commission to distributors shall be paid by the investor to the distributor directly. The distributors shall disclose the commission, trail or otherwise, received by them for different schemes/ mutual funds which they are distributing or advising the investors."

The guideline suggests that the practice of fund houses deducting an entry load (from the sum invested) and paying the same to distributors (investment agents/advisors) as upfront commission will be discontinued. Instead, the investor will have to compensate the distributor for the services rendered. Also, distributors shall be obliged to reveal the total commission they earn from various mutual funds.

So let's see, what's causing all the hoopla? Have distributors been deprived of their livelihood? Does the regulation suggest that henceforth distributors will have to treat selling mutual funds as a philanthropic activity? No. So why all the fuss? Here's why. Thanks to this step, distributors have been made accountable. They can no longer operate with a "the more I sell, the more I will earn" mindset. With an assured income of 2.25% or thereabouts from the entry load, aspects like quality of advice and service were rarely granted any importance. However, that modus operandi is now history. Several distributors will have to kiss a tearful goodbye to the 'easy money' route. And this is where all the agony stems from!

Any distributor who is confident about the quality of services he offers, should welcome this step. Nowhere does the guideline suggest how much income the distributor can demand from the investor. So if the distributor provides quality advice that is consistently in the investor's best interests and backs it with top-notch service, he could potentially demand more than the 2.25% that was available to him via the erstwhile entry load. Hardly a reason to complain!

Now for the second part of the guideline - disclosing all commission earnings. Again, distributors only have themselves to blame. Having built a reputation for selling mutual funds that offer them the highest commission, mis-selling continues to be common practice in the mutual fund industry. SEBI is simply trying to incorporate greater transparency in the investor-distributor association. Distributors who do not engage in any malpractice have no reason to fear. They should be able to justify why they are recommending a given fund vis-à-vis another.

Some fund houses are apparently aggrieved since they believe that the mutual fund industry will suffer, since distributors will gravitate towards insurance products offering better commission. Hence fund houses will end up with lesser assets to manage. Of course, a smaller asset size translates into lesser income for the fund house.

Here's a counterargument - if the mutual funds on offer are attractive enough and can aid the investor in achieving his investment goals, he will demand them and thereby create a demand. And the onus to ensure that funds are attractive lies primarily with the fund house. Also, if a fund house feels that distributors deserve to be better compensated, it is free to cough up additional benefits out of its own pockets. Remember the regulator only stipulates how much expenses can be charged to the fund (i.e. borne by the investor). Any fund house/AMC which believes that distributors are being short-changed, should feel free to reward them out of its own coffers.

Time and again, fund houses have failed to act in the best interests of the investor. Their partisan attitude towards distributors and indifference towards investors has been disappointing to say the least. Let's hope this time around better sense prevails and they don't create any roadblocks in the implementation of this directive.

As for investors, they couldn't ask for more. First, they were given the opportunity to invest directly with the fund house, thereby bypassing the distributor and avoid paying an entry load. Now with the guideline to scrap the entry load, they can negotiate with the distributor and arrive at a fair price for the latter's services. The onus to make the most of this opportunity lies with investors.

Kudos to SEBI for taking a stand for investors!

Distributors and fund houses - keep your chin up. This round goes to investors!

Look who's talking!

Mutual funds are back with a bang! Pick up any newspaper and you are bound to come across a mutual fund related write-up or advertisement. Given the surge in equity markets, the performance of mutual funds has started looking up. And fund houses are sparing no effort (explicit or implicit) to spread the gospel of mutual funds. There are articles eulogising the impressive showing delivered by mutual funds in the recent past; also, the fact that the mutual fund industry now holds a record assets under management (AUM) size has been well-documented. Fund managers are busy giving out interviews highlighting how mutual funds will hold investors in good stead over the long-term. Dividends are being declared in a hurry by several funds to prove their prowess. Finally, some new fund offers (NFOs) have already been launched (more on this later in the article) and several others are on the way. All in all, it can be safely stated that mutual funds are back with a bang!

Circa October 2008
Not too long ago (October 2008 to be precise), the scenario was radically different. Equity funds had been hit hard by the sharp decline in equity markets; even 3-Yr performance numbers were in negative territory. Debt offerings like fixed maturity plans (FMPs) and liquid/liquid plus funds had come under the scanner on account of the liquidity crisis; questions were being raised about the quality of investments made by several funds. Simply put, mutual funds had become everyone's favourite 'whipping boys'. While all the criticism may not have been justified, some of it certainly was.

Interestingly, the response of fund houses to the demanding situation was rather curious. Most fund houses went into a 'silent' mode and simply chose not to react. When relationship managers were contacted for information about their funds, the standard response was, "everything is fine; there is nothing to worry about". Requests for one-on-one interviews with fund managers were either instantly turned down on the grounds that the fund manager was busy or stalled with the excuse - "we'll get back to you on this one". While some fund houses/fund managers were willing to go on record about the nature and quality of their fund portfolios, they were strictly in a minority.

Odd isn't it. In a time of crisis, fund houses, instead of communicating with investors to assuage their concerns, chose to go into hiding. And now, when the going is good, fund houses are acting like 10-yr old over-energetic blabbermouths who can't keep mum. That tells you something about fund houses, doesn't it?

As for the NFOs, at any sign of rising markets and a revival in investor interest, they make a comeback. Already, we have had a round of the 'target return' NFOs. Simply put, these are funds wherein there is an inbuilt clause for booking profits when a certain return (as specified by the investor) is clocked. In most cases, the profits are booked and invested in a debt fund from the same fund house. For investors who were ruing the fact that they didn't book profits when markets peaked in January 2008, only to see the value of their investments plummet subsequently, these NFOs struck a chord.

Here's a thought - is it prudent for mutual funds to book profits for investors or is that something investors should be independently dealing with after taking into account factors like their individual financial goals, the investment scenario and the performance of their investment portfolio as a whole. Also, let's not forget that regularly 'booking profits' for every individual investor at a fund level, just might force the fund manager to prematurely sell some quality stocks from his portfolio. This in turn, could be detrimental to the long-term interests of the fund.

But given the receptiveness shown by investors, fund houses were only more than happy to launch a slew of 'target return' funds. Some introduced the facility to book profits in their existing funds. Of course, the fact that even after booking profits, (on account of transfer of profits booked into a debt fund) there is no fall in the AUM of the fund house doesn't hurt the latter's cause. Rest assured, with the markets moving northwards at a brisk pace, it's only a matter of time before a number of NFOs hit the markets.

What investors must do
Given that fund houses have failed to distinguish themselves, it is fair to state that investors would do well not to blindly follow them while making investment decisions. Going forward, fund houses will try to entice investors by making them believe that all is hunky dory and now is the time to get invested lock, stock and barrel. Can't blame them, it's the AUM that translates into income for them. Hence, higher the AUM i.e. more investments made by investors, the better it is for fund houses.

On the other hand, investors need to be a lot more pragmatic. They should not get carried away by all the hype being whipped up by fund houses. Instead, they should use the downturn and despondency that they witnessed and experienced not too long ago, to make a fair evaluation of their risk-taking ability. This can help them determine what portion of the investment portfolio should be allocated to mutual funds. While no one would dispute the ability of well-managed mutual funds to add value to investors' portfolios, there is certainly a need to guard against making investments in a reckless manner.