Why SEBI’s Guidelines on Mutual Funds’ Categorization and Rationalization are Flawed

Market regulator SEBI has issued a circular defining categories for mutual fund schemes, and the number of funds permitted under each category. Consequently, fund companies will be forced to either merge or liquidate all additional schemes.

For some time now, there have been rumours that SEBI has been nudging fund companies to reduce the number of schemes on offer. By issuing a circular, SEBI has forced fund companies to act.

I have no hesitation in saying that several Indian fund companies have been poor stewards of investors’ monies. They have been guilty of recklessly launching funds (often with poor investment rationale) with the sole intent of shoring up assets.

Furthermore, I believe that SEBI acted with the best of intentions, to aid investors make informed decisions by easing the selection process.

That said, I’m afraid that SEBI’s solution is flawed because it lacks nuance, and is unlikely to result in an improved investment experience for investors.

Is fewer options necessarily better?

Clearly, the guidelines are aimed at (a) reducing number of funds and, (b) bringing uniformity among funds in each category.

So, if the new fund offer (NFO) launch spree resulted in too many funds (read choices) for investors. SEBI's solution is on the other end of the spectrum—extinguish a number of funds, thereby sharply reducing choices available to investors. I'm not convinced that the latter is necessarily in investors' best interests.

Let's take an example to better understand why limiting choices need not be a good idea.

With the exception of three categories, the guidelines state that one fund is permitted per category. Hence each fund company can have say, one Large Cap fund.

Even a cursory glance at the present large cap funds reveals that there exist funds of different hues and colours.

There are funds that take cash calls, and others which are fully invested at all times; some which adopt a buy-and-hold stance and others that churn the portfolio rapidly; funds with benchmark-agnostic and benchmark-aligned portfolios.

Many of these contrasting investment styles can be found in the same fund company. Each investment style is apt for an investor with a distinct risk profile.

However, SEBI's guidelines could result in investors not having access to funds that are apt for them.

In a move that is seemingly at odds with what the guidelines aim to achieve, categories such as Dividend Yield Fund and Value/Contra Fund have been permitted. But how does one define what constitutes a dividend yielding stock, or a value/contra pick for that matter? One can’t since, there is no universal definition.

In effect, fund companies have been handed a loophole that they can freely exploit. Such a scenario can negate SEBI’s intent to ‘standardize characteristics of each category’.

Status quo for close-ended funds

In a major gaffe, the guidelines are applicable only to open-ended funds. The close-ended funds segment, which is a hotbed of questionable funds with little differentiation, and rampant mis-selling will continue to thrive.

I won’t be surprised if we see a large number of close-ended NFOs being launched in the days to come.

Bloated asset sizes of merged funds

To my mind, not many funds will be liquidated in light of the ‘one fund per category’ rule. Liquidating funds means loss of assets, and in turn, loss of revenue for the fund company.

Instead, we will see a record number of mergers. In several cases, the merged fund will have a bloated asset size making it unwieldy. Liquidity management issues could crop up, adversely affecting the performance. 

All in all, the guidelines may have been well-intentioned, but I fear this will end up as a case of throwing out the baby with the bathwater.

Why Union Budget 2017 Must Give the Nod to Target-Date Funds

In its February 2014 board meeting, market regulator SEBI alluded to “a long term product such as Mutual Fund Linked Retirement Plan (MFLRP)” as a part of its 'Long Term Policy for Mutual Funds in India'. Since then, some fund companies have launched their versions of retirement funds.

However, the regulator is yet to issue guidelines to pave the way for a defined MFLRP product. With Union Budget 2017 on the anvil, one hopes that the MFLRP segment is promulgated in the form of Target-Date Funds.

What are Target-Date Funds?

As the name suggests, target-date funds focus on a pre-set year of retirement. For instance, if you are 30 years of age, and intend to retire at the age of 60, then you will invest in a fund with a target date of 2047.

Target-Date funds are structured as fund-of-funds. They operate on the principle of asset allocation. In their initial years, target-date funds focus on wealth accumulation by largely investing in a combination of domestic and global equity funds. As the target-date approaches, the portfolio acquires a conservative bent with equity allocation being trimmed in favour of fixed income funds.

Simply put, a target-date fund can be a one-stop shop for accumulating a retirement kitty.

In the US, several billion dollars are invested in target-date funds. It certainly helps that target-date funds are often the default choice under defined contribution plans such as 401(K).

Retirement Planning and India

While awareness about retirement planning has grown over the last decade or so, it continues to be a bit of an alien concept for several Indians. Perhaps one can chalk it up to cultural factors. We have been a country of joint families wherein post-retirement, parents are provided for by their children. But thanks to a combination of factors such as growth of nuclear families, higher life expectancy, and cost of living, the need for retirement planning is real.

Successive governments have nudged citizens to independently provide for retirement as well: From opening up the National Pension System (NPS) for all citizens in 2009, enhancing its tax sops in Union Budget 2015, to launching the Atal Pension Yojana for those in the unorganised sector. The message is clear: Focus on retirement planning.

Tax Treatment and Benefits

The allure of tax benefits can be a strong motivator while making investment decisions. Let’s take the example of Equity Linked Savings Schemes (ELSS), a niche segment in the Indian mutual fund industry with assets of INR 501 bn (3% of industry assets) as on Dec 2016.

From Dec 2011 through Dec 2016, assets under ELSS have risen at an annualised rate of roughly 20%. That is no mean feat considering that the investments are subject to a three-year lock-in. To put things in perspective, over the same period, the broader category of other equity funds has grown by 25%.

So, what makes the niche ELSS category tick—tax benefits! Investments in ELSS are eligible for deductions under Section 80C of the Income Tax Act.

To enhance the appeal of target-date funds (and thereby facilitate retirement planning), it is pertinent that investments therein be made eligible for Section 80C deductions.

Another area which must be simultaneously addressed is the tax treatment of fund-of-funds. In India, fund-of-funds never took off. While the latter can be attributed to a variety of reasons, none is more significant than tax treatment.

Irrespective of their underlying investments (equity funds or fixed income funds), fund-of-funds are taxed akin to fixed income funds. Since the tax treatment for fixed income funds is more punitive (versus equity funds), fund-of-funds have been at a disadvantage.

Hence the need for regulatory intervention to ensure that target-date funds enjoy the same tax treatment as equity funds. And what better platform than the Union Budget to iron out these regulatory matters, and launch target-date funds on a strong footing.

How the Investor Wins

Presently while planning for retirement, investors can choose from NPS, small savings schemes (Public Provident Fund) and retirement plans of insurance companies. Target-date funds can effectively close the circle of retirement-focused avenues. 

The potential for ancillary benefits—inflow of long-term monies into mutual funds, greater influence of domestic institutional investors in markets, multiplier effect of higher consumption from retirees—is strong.

Hopefully, the Finance Minister will agree, and give the nod to target-date funds in Union Budget 2017.

Mr. Portfolio Manager: It’s About Conviction, Not Guarantees

Over the years, in my several interactions with portfolio managers most have claimed to be big investors in funds they run. Perhaps it was politically correct to do so. Then again, there was no way to independently verify their claims. However, with market regulator SEBI mandating that investments made by managers and the fund company's top brass be disclosed, the scenario has changed.

The disclosures have been startling to say the least. Several long-tenured managers running large diversified funds have nominal investments to show for, while others have chosen not invest in their funds. It can be safely stated that the principle of having ‘skin in the game’ hasn’t been embraced by many managers.

Recently, a manager who has no investments in his funds came up with a novel justification. He stated that a ‘manager investing in his own fund doesn’t guarantee performance’; hence, his investments (or lack of them) are immaterial. To clarify, he isn’t the only manager to have taken that stand. In my opinion, this line of thought is both naive and flawed.

Given their market-linked nature, mutual fund investing entails taking on risk. While the degree of risk may vary depending on the kind of fund chosen, risk is pervasive nonetheless.

So how do investors mitigate risk? By performing an evaluation. For instance, some may focus on quantitative parameters such as past performance, risk-return showing, while others emphasize on qualitative factors—manager skill, investment process et al. It isn’t uncommon for investors to combine the two either.

The portfolio manager’s investments in funds he runs is yet another evaluation tool. A manager investing substantial monies in his funds demonstrates conviction in his investment approach and acumen. It’s a classic example of putting one’s money where the mouth is.

None of the evaluation parameters can guarantee performance. But that in no way diminishes their relevance. Of all people, a portfolio manager should be aware that there are no guarantees in his domain. Investing in markets akin to a business of risk, not a business of guarantees. Does the fact that there is no guarantee of returns, prevent the manager from exhorting investors to invest in funds he runs?

I have no doubt that some managers will continue to steer clear of investing in funds they run. But they would do well not to trivialise the importance of having ‘skin in the game’ using inane arguments. As for investors, I am certain that like me, most will be wary of the chef who doesn’t eat his own cooking.

What Executive Remuneration Disclosures Reveal About Fund Companies

In March 2016, SEBI issued a circular mandating that the remuneration of every fund company’s top brass be disclosed. Apart from the remuneration of the CEO, CIO and COO, the circular requires that fund companies publish a list of employees whose annual remuneration is equal to or above INR 6 million, and also the ratio of CEO's remuneration to median remuneration of employees.

Some fund companies have recently released the requisite information on their websites. In an earlier post, I had expressed reservations regarding the utility of these disclosures. Interestingly, the manner in which disclosures have been made, has unintentionally revealed more than the disclosures themselves.

To begin with, despite the deadline not all fund companies have made the relevant disclosures at the time this post was written. Perhaps SEBI-mandated disclosures aren’t important for some fund companies.

At their core, the said disclosures are intended at empowering investors. Hence it would be reasonable to assume that investors should be able to easily access them. Is that the case? Let’s find out.

Of the top 10 fund companies (which account for roughly 80% of industry assets; read substantial investor interest), four—Birla Sun Life Mutual Fund, SBI Mutual Fund, UTI Mutual Fund and Franklin Templeton Mutual Fund—haven’t disclosed executive remuneration as yet.

A common thread running through the balance six fund companies is that only existing investors can access the information. In other words, a prospective investor who may want to use the information to make an investment decision is unable to do so.

Furthermore, before accessing the information, investors are required to agree to a long list of terms and conditions which among others, state that the information shall not be shared with anyone in any form or manner. In other words, the disclosures are confidential in nature; oxymoron anyone?

Now let’s delve into how fund companies fare in terms of accessibility of disclosures. Of the top 10, HDFC Mutual Fund fares well. Investors can access the requisite information after entering two data points and a CAPTCHA. All the information is available on a single web page, and can be easily copied into other user-friendly formats.

Accessing data on Reliance Mutual Fund’s website is trickier. It helps to have a registered mobile number which can be used to generate a One Time Password. Alternatively, a combination of two or more data points are required. While the information is available in a single web page view, it cannot be copied into another format.

ICICI Prudential Mutual Fund fares worse offering access to only one executive’s remuneration at a time. In other words, one needs to tediously move back and forth to access multiple data points.

While accessing information from IDFC Mutual Fund requires two data points and a CAPTCHA, Kotak Mutual Fund demands six data points.

DSP BlackRock Mutual Fund holds the dubious distinction for being most secretive while disclosing executive remuneration. Data entered on the website leads to an auto-generated mail being triggered to the investor’s registered email-id. Clicking on a link therein takes the user to a webpage wherein the investor can request for one executive’s remuneration at a time. Following this a message flashes “Your request for information has been registered. Our Human Resources team will reply to you shortly”. I am yet to receive any information despite passage of over 24 hours.

However not all fund companies fail to pass muster. Two of the smallest fund companies—Quantum Mutual Fund and PPFAS Mutual Fund—have followed the disclosure norm in letter and spirit. Not only is executive remuneration-related information freely available on their websites (in other words, one need not be an investor to access the information), the information can be conveniently accessed in the PDF format. 

It’s quite likely that in the days to come, SEBI may issue guidelines standardising the manner in which executive information must be disclosed. However at present, when fund companies are using their discretion to disclose information, speaks volumes about their attitude towards investors.

Direct Plans: Much Ado About Nothing

Admittedly, when I first heard someone complain about direct plans, I was surprised. But over time, the negative buzz has only grown. A few months ago, I met some individuals who are engaged in mutual fund distribution. Their grouse was that introduction of direct plans has resulted in a significant loss of business for smaller distributors like them. They were convinced that it was only a matter of time before all mutual fund investors migrated from regular plans (wherein the expense ratio includes distribution expenses, commission et al) to direct plans.

Then there were investors who were unhappy with their investments in direct plans. They maintained that direct plans were responsible for their woes. Things came to a head last month when SEBI issued a circular mandating that fund houses disclose information regarding commission paid to distributors, among others. Some concluded that this was a sly move to promote direct plans at the cost of regular plans.

In all the aforementioned cases, direct plans were painted as villains of the piece. But do those arguments hold weight?

       

Let’s consider the first grouse: direct plans have resulted in small distributors substantially losing their business. As per data released by AMFI, as of Feb 2016, “39% of the assets of the mutual fund industry came directly. A large portion of direct investments were in non-equity oriented schemes where institutional investors dominate”.

It is common knowledge that most institutional investors were (and continue to be) serviced by large distributors i.e. distribution arms of banks, broking firms and distributors with a nationwide presence. So it can be safely stated that institutional monies flowing from distributor mode to direct mode hasn’t had a significant impact on small distributors.

Now let’s focus on retail investments i.e. the universe largely catered to by small distributors. AMFI data reveals that of the total industry assets (INR 13.5 trillion), roughly 44% were held by individual investors; of these just 13% were invested in direct plans.

It is noteworthy that direct plans with a lower expense ratio have been on offer since Jan 2013. In other words, even after more than 36 months, a bulk (87%) of retail assets continue to be invested via distributors. The much-feared and speculated exodus of retail assets from distributor to direct mode hasn’t taken place.

The second grouse—investors expressing dissatisfaction with direct investments—has its roots in a half-baked understanding of how direct plans should be utilised. After they were introduced, benefits of direct plans (lower cost versus regular plans, and thereby higher performance potential) were universally extolled. Expectedly, some investors decided to invest independently, and chose direct plans over regular plans. However while doing so, several overlooked an important caveat: direct plans are meant for informed investors who can make investment decisions independently.

Not all investors who severed ties with their distributors were capable of investing prudently. To further complicate matters, their chosen alternative for the distributor—experts in media—left a lot to be desired. Experts offering generic opinions on investing in the media doesn’t necessarily qualify as investment advice.

A distributor offering advice based on the investor’s risk profile, investment objectives and horizon cannot be substituted by a media talking head. The need for robust investment advice was accentuated in the last 18 months or so, when markets were at their volatile best. Sadly, some investors have erroneously chosen to blame direct plans for their woes.

The merits of direct plans are indisputable. Indeed, their introduction has gone a long way in democratizing mutual fund investing. 

For investors who need investment advice and services, engaging a distributor and investing in regular plans is a viable option. Conversely informed investors can utilise direct plans and benefit from lower costs. The onus of making the apt choice lies with investors.

Why Investors Must Cheer SEBI’s Initiative On Mutual Fund Disclosures

Last week, market regulator SEBI released a circular that among others, enhances mutual fund disclosures. The new directives have the potential to be game changers.

Let’s start off with the disclosure that has garnered most attention—commission paid to distributors. SEBI has ruled that henceforth half-yearly account statements sent to investors will have information regarding commission paid to distributors. Commission has been defined to include both monetary and non-monetary payments made by the fund company to the distributor. Furthermore, the statement will also have information regarding expense ratios (for both regular and direct plans).   

Some quarters are up in arms against this ruling. While some feel that disclosing commission-related information will push investors towards direct plans, others argue that this is a conspiracy to ease out small distributors. I believe the reservations are a case of stretching the point.

Fund companies pay commissions to distributors for selling their products (and rightly so!); all they need to do is disclose the same to investors (who bear the cost). No one’s suggesting that fund companies must stop compensating distributors. Also, to assume that an investor who is satisfied with his distributor’s service, will turn his back on the same and opt for a direct plan, because the commission is disclosed is a fallacious argument. So long as the distributor adds value, the investor will continue to be associated with him.

In the confusion, most have overlooked what to my mind is the most important ruling—investments in funds by portfolio managers and other personnel. From May 2016, every fund’s Scheme Information Document (SID) will have information related to investments made by the fund’s portfolio manager(s), the AMC’s Board of Directors and other key managerial personnel.

The rationale behind this move is to encourage the concept of ‘skin in the game’. The concept is far more common in the West, than in India. For instance since 2005, the U.S. Securities and Exchange Commission has required fund companies to annually disclose how much portfolio managers invested in the funds they run. At its core, 'skin in the game' is about inspiring confidence in investors. Managers who invest alongside their investors show conviction in their investment approach and acumen. It’s a classic example of putting one’s money where the mouth is. This regulation offers investors insights into funds, and the opportunity to evaluate them in a manner hitherto unavailable.

Then there’s the directive on soft-dollar arrangements. So far, investors have been blissfully unaware of soft-dollar arrangements between fund companies and brokers, and how the same impacted their investments. SEBI has decided that henceforth, soft-dollar arrangements will be limited to benefits that are in the interest of investors, and the same shall be disclosed.

Admittedly, some rules seem odd—it has been mandated that compensation of the fund company’s top brass be disclosed. Likewise, fund companies will have to publish a list of employees whose annual remuneration is equal to above INR 6 million, and also the ratio of CEO's remuneration to median remuneration of employees. I fail to see how these provisions can help investors make better investment decisions. Investors’ interests would have been better served if the method of computing annual remuneration had been disclosed. That way, investors could have comprehended what fund company top bosses are mainly compensated for—growing assets or fund performance.

That said, all in all, the mandated disclosures have the potential to usher in an era of transparency in the mutual fund industry. However, one must understand that a disclosure (read transparency) isn’t an end in itself. Learning more about funds should translate into informed investment decisions, and in turn, goals being achieved. The onus to make the most of the information on hand, lies on investors, advisers and distributors alike.

Why Indian Fund Companies Shouldn’t Fear Greater Transparency

Media reports suggest that several Indian fund companies are at loggerheads with market regulator SEBI. The latter wants to increase transparency by disclosing commissions paid to distributors in investors’ statements of accounts. On the other hand, fund companies believe that doing so will be detrimental to their interests. According to reports, industry body AMFI has communicated its reservations to the regulator.

Reasons for opposing the move are varied: some fund companies think disclosing commission-related information will dissuade investors. Others feel that bombarding investors with too much information will be detrimental. 

To my mind, the concerns raised by fund companies are both misplaced and weak. To begin with, the proposal doesn’t alter the working of the fund industry in any manner. Fund companies pay commissions to distributors for selling their products (and rightly so!); all they need to do is disclose the same to investors (who bear the cost). No one’s suggesting that fund companies should stop compensating distributors.

As for fears of investors becoming upset by learning about commission payments, or becoming confused on account of too much information—those are weak arguments. Fund companies would do well not to underestimate the investor’s intellect. To assume that an investor who is satisfied with his investment will turn his back on it, because the agent’s commission is disclosed is a fallacious argument.

When an investor invests in a mutual fund, effectively he engages a fund company to manage his monies. The fund company charges a TER (comprising everything from operational expenses, the fund company’s fees, to the distributor’s commission) for the service. An unambiguous disclosure will aid investors better understand the fund’s working, and thereby make informed investment decisions.

For instance, a fund company which keeps costs (including fees and commissions) low and thereby enhances the fund's returns can benefit by communicating the same to investors. It can be safely stated that such disclosures will go a long way in winning investors’ patronage.  Conversely, the investor has a right to know if his fund is losing its competitive edge on account of exorbitant commission pay-outs.

Case for more disclosures

I’m surprised that in its quest for greater transparency, SEBI didn’t start at the top of the pyramid i.e. with fund companies. There is a strong case for making public, information related to the fund company’s compensation policy for its investment staff (portfolio managers and analysts), and also information regarding a portfolio manager’s personal investments in funds he runs.

Taken together, the two can reveal a lot about the fund company’s culture, its attitude towards investors, and a manager’s commitment to his fund—all of which can be vital in helping investors make better decisions. 

Admittedly, from the perspective of fund companies, revealing information that hitherto was private can be discomforting. But it is in their interest to embrace this change. Greater transparency isn’t an end in itself. The intent is to improve investors’ investment experience, and in turn make mutual funds more appealing. And when the investor wins, so will fund companies.

Debt Funds: Liquidity Matters, But Managing Liquidity Is The Key

Recently, I read an article written by an individual who is considered an expert on mutual funds. Weighing in on the ongoing debate of debt funds taking credit risk, he came up with an interesting solution--modify the structure of funds investing in illiquid securities, whereby redemption requests don’t have to be met immediately. The rationale being: the combination of investments in illiquid securities and an immediate redemption facility is at the root of the crisis. Hence the solution lies in permitting fund houses to make delayed redemptions. 

On the face of it, the recommendation seems reasonable. But scratch the surface, and the solution will appear simplistic. Here’s why:

To begin with, in a mutual fund, a portfolio manager’s role is not restricted to just identifying lucrative investment opportunities, and making timely investments. His ability to proficiently managing liquidity in the portfolio is no less important. Skilled portfolio construction can enable a manager to navigate unexpected market events (and handle redemption pressure) without unsettling the portfolio, or with minimum disruption to the portfolio. In other words, the presence of illiquid corporate debt in the portfolio need not make the portfolio illiquid. Indeed, liquidity management is one of the parameters on which the manager and his investment process must be evaluated. It is inexcusable for a manager to compromise the portfolio’s liquidity in a bid to clock higher returns. To my mind, such a scenario portrays the manager’s investment skills in poor light.

Furthermore, defining what constitutes a liquid investment is easier said than done. For instance, to suggest that only corporate bonds are illiquid wouldn’t be accurate. A cursory glance at data for trades in the benchmark 10-year GOI bond versus those for other GOI bonds reveals a telling picture. Market conditions and sentiment can significantly impact liquidity. In buoyant markets, the corporate debt segment can be more liquid than in a downturn. A parallel can be drawn for equity markets as well, wherein small/mid-caps typically tend to be more liquid during an upturn. Clearly, defining which funds invest in illiquid instruments (as has been suggested in the article) is more complicated than it has been made out to be.

Finally, there’s a need to discuss where the onus must lie: should investors be asked to tone down their expectations on the liquidity front, or should fund houses be responsible for performing better on the liquidity management front? 

In many ways, the financial crisis of 2008 proved seminal for the Indian mutual fund industry. Several debt funds (including close-ended products such as fixed maturity plans) witnessed extraordinary redemption pressure. Subsequently, SEBI put safeguards in place by prohibiting fund houses from providing premature redemption for close-ended funds and defining the investment profile for liquid funds, among others. Some fund houses and managers went back to the drawing board and re-evaluated their investment philosophy, especially for the debt funds segment. In turn, this equipped them to better manage liquidity in their portfolios. 

Present regulations governing redemptions are not only comprehensive, but reasonably indicative of how investments should be made. Hence, there is no valid reason for creating a third structure (a middle ground between open- and close-ended funds) to make up for a fund house/manager’s incompetence. As for fund houses which can’t make the grade, the ‘perform or perish’ maxim is apt. 

Don't Treat Debt Funds Taking Credit Risk Like Pariahs

The JPMorgan Mutual Fund episode continues to reverberate in the investment community. The focus has seemingly shifted from the two affected funds to the investment strategy of taking credit risk (also referred to as high-yield investing). Media reports suggest that market regulator SEBI has sought details on investments in lower-rated securities from fund houses; also, it has been reported that SEBI has asked fund houses to not rely solely on credit ratings while investing in debt securities. Consensus suggests that fund houses have erred by taking credit risk, and as a result, investors’ interests have been compromised with. But this line of thinking is both myopic and fundamentally flawed.

To begin with, let’s understand what the strategy of taking credit risk (or high-yield investing) entails. The portfolio manager invests in securities with a lower credit rating. Such instruments offer a higher coupon rate (versus securities with a higher credit rating); furthermore, there is a possibility of the bond price appreciating if the credit rating is upgraded. Does this investment strategy entail risk – yes, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal amount. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risks, did fund houses and portfolio managers err by adopting a credit-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several managers have plied it successfully and delivered pleasing long-term results for investors. That the strategy entails risk doesn’t make it faulty. Some experts have claimed that investors are better off investing in debt funds that follow the duration strategy. That’s a weak argument because failing to accurately read the direction in which interest rates will move can also lead to losses.

The only reason funds with credit risk are in focus at the moment is the JPMorgan Mutual Fund episode. Oddly, over the years when these funds delivered attractive returns (and inherent risks didn’t surface) no concerns were raised. Therein lies the crux of the matter. Mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent. 

Treating debt funds with a credit strategy like pariahs is a knee-jerk reaction. A prudent approach will be for investors to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

For instance, before investing in a debt fund wherein the credit risk strategy is employed, investors must ask themselves the following questions:

• Does their risk appetite allow them to invest in the fund?

To gauge one's risk-taking ability, it might help to visualize a scenario wherein testing conditions (read more downgrades and underperformance) prevail for a prolonged period. If investors believe that they are likely to push the panic button, then these funds aren’t for them. 

• What is the apt allocation for the fund in the portfolio? 

An investment advisor/financial planner can help decide if the fund should be utilised as a core holding or a supporting player in the portfolio. Clarity on this front will also help pragmatically evaluate performance, and decide on the fund's continuation in the portfolio.

• Is the portfolio manager adept at taking credit bets?

Not every manager has the skills to successfully ply the strategy. It is pertinent that the manager’s skills are in sync with the strategy. Seek managers who have conviction in the strategy over those who deploy it because it is the flavour of the season.

• Is the fund house trustworthy? 

Notwithstanding the kind of fund investors are seeking, the importance of being invested with the right fund house cannot be overstated. This aspect is only accentuated in times of adversity. Investors should select fund houses which have a track record of being investor friendly.

Why Mutual Funds Must Stop Peddling Surrogate Advertisements Under The Guise Of Investor Education

This week, the front page of a business daily carried an advertisement from a fund house. The full-page advertisement had been issued to ‘educate’ investors about the benefits of SIP investing. On the next page, appeared another mutual fund advertisement; ‘issued in public interest’, this one spoke about investing in equity and debt schemes to balance the portfolio.

Both advertisements had apparently been issued to educate interests. But it was evident that they had little to do with investors’ education or interests. Rather, they were surrogate advertisements for promoting fund houses, with names, logos, websites and toll-free numbers being prominently displayed. Sadly, this practice has become the norm in the Indian mutual fund industry. When market regulator SEBI mandated that mutual funds spend monies on investor education, this is not what it intended.

The SEBI circular

In September 2012, SEBI issued a circular wherein it was stated that “Mutual Funds/AMCs shall annually set apart at least 2 basis points on daily net assets within the maximum limit of TER as per regulation 52 of the Regulations for investor education and awareness initiatives”. 

Ever since, fund houses have been at their creative best using various media to promote themselves under the guise of investor education. The pattern is predictable—throw in a line or two about investing such as “ELSS can help you save taxes” or “Debt funds can help you achieve your goals”—followed by a prominent display of the fund house’s name, logo, website et al. A classic case of killing two birds with one stone: fulfil a statutory requirement and yet indulge in self-promotion. 

As per media reports, at a recent seminar, SEBI chief Mr. U. K. Sinha was quoted as saying that only 18% of the investor education programmes conducted by fund houses had genuine investors. 

It will be interesting to find out what portion of the monies earmarked for investor education, has been spent by fund houses on surrogate advertisements aimed at self-promotion.

Fund houses’ perspective

It’s quite likely that some fund houses believe that they have been given a raw deal by being asked to spend on investor education. A fund house is a commercial enterprise whose primary activity is to manage investors' monies for a fee. Hence the thinking that they should try to get maximum bang for the buck by promoting themselves while spending for investor education. The trouble with this approach is that it displays myopic thinking and a poor understanding of the investment environment.   

Wary mutual fund investors

To better understand why fund houses’ approach is flawed, let’s step back in time to 2011, a year that proved seminal for the mutual fund industry. After equity markets turned around sharply in 2009 and the continued to fare well in 2010, came the downturn of 2011. Markets posted a loss of roughly 25%; for investors, this proved to be the proverbial straw that broke the camel’s back. Perhaps painful memories of the 2008 global meltdown were refreshed.

Over the next 24 months (Jan 2012 through Dec 2013), the equity mutual funds segment (equity funds, balanced funds and ELSS) witnessed net outflows of roughly INR 275 billion. Such was the pessimism, that investors even ignored the fact that over this period, markets posted a gain of 36%. 

Optimism returned only when general elections approached and expectations of a new government were omnipresent. On the back of markets scaling record highs, the equity funds segment saw net inflows of INR 1,285 billion from Jan 2014-June 2015. But as is often the case, a bulk of the monies came in after the markets had already run up sharply; in effect, yet again investors missed the inflection point.

The need for informed investors

The numbers say it all. The 2011 downturn deterred a substantial number of mutual fund investors for the two subsequent years. Later in 2014, when a ‘hope’ rally set in, investors were willing to return to mutual funds. This isn’t the investment pattern one would expect from informed investors. It wasn’t just mutual fund investors who lost out; declining assets also translated into loss of revenues for fund houses. 

Had the average investor been better informed, the scenario could have been significantly different, and better for both investors and fund houses. Hence the need for fund houses to adopt a more pragmatic approach while spending on investor education. While the present approach of surrogate advertising could yield short-term benefits, it is unlikely to amount to much over the long-haul. 

Don’t get me wrong. I am not suggesting that it is the sole responsibility of fund houses to educate investors. Far from it. The biggest onus is on investors themselves. But fund houses must do their bit as well, because it is in their interest to do so. Simply put, if not philanthropy, commercial interest should motivate them to act aptly. 

For far too long the Indian mutual fund industry has depended on monies from institutional investors who largely invest in debt funds. It is time for fund houses to start paying more attention to retail investors who account for a bulk (roughly 84%) of the equity assets. Not only are equity assets stickier, they also generate more revenue for fund houses (versus debt funds). Prudent investor education initiatives can go a long way in creating a breed of smarter retail investors.   

One of my former bosses used to say “if the investor wins, we all win”. It’s time the mutual fund industry took some inspiration from that quote and treat investor education with the gravity that it rightfully merits.

Data sourced from: www.amfiindia.com and www.bseindia.com

What HDFC AMC must do now...

HDFC Asset Management Company (AMC) is in the news, and sadly, not for the right reasons. If media reports are to be believed, the AMC has been served a show cause notice by market regulator SEBI. The front-running scandal which first surfaced in June 2010 has returned to haunt the AMC, with apparently more instances of questionable trades being uncovered. The popular belief that the matter had been laid to rest when the AMC and its managing director settled charges by paying fines was obviously incorrect.

There is a legal aspect to the episode which the fund house's legal team will undoubtedly deal with. However, to my mind, there's another side—pertaining to the AMC's stewardship—which is even more significant. In the mutual fund business, the importance safeguarding and acting in investors' interests cannot be overstated; likewise, it would be imprudent to undermine the significance of investor confidence and trust. On those counts, now is the time for HDFC AMC to step up to the plate.

The need to act is only accentuated by HDFC AMC's standing in the industry (remember the Spider-Man credo: with great power comes great responsibility). Not only is it among the largest fund houses, in my opinion HDFC AMC easily ranks among the best players in the Indian mutual fund industry. A disciplined investment process and a consistent long-term focus have contributed to the fund house's sterling reputation in no small measure. In an industry where high manager turnover is the norm rather than the exception, the AMC has been successful in both attracting and retaining talent over the long-haul. Performance-linked compensation structures ensure that the investment team's interests are aligned to those of long-term investors. It can be safely stated that the fund house fosters an investment culture rather than a marketing culture.

All the positives notwithstanding, it is disconcerting to hear that there is a likelihood that more questionable trades may have taken place, and that the AMC finds itself on the wrong side of the law yet again. HDFC AMC must assuage concerns of its stakeholders (read investors and distributors). And here's how they should go about doing so. 

To begin with, the AMC must start communicating. Instead of learning about the developments from the media, it would help if HDFC AMC were to communicate with its stakeholders and offer its side of the story. Don't get me wrong: I'm not suggesting that nitty-gritties of the legal proceedings or confidential matters be placed in public domain. But the AMC can and must offer its stance to let its stakeholders know that all is in order. If is as being alleged, questionable trades did indeed take place, then an apology is in order. All it takes is an unambiguous and forthright note from someone in the top brass, which can be put up on the AMC's website.

Then there's compliance; presumably, the AMC has already taken steps to ensure that irregularities such as front-running do not recur. It would help if the same are communicated to investors as a part of the confidence-building measure.

Finally, the AMC must also chart out a plan to compensate investors for losses suffered as a result of the alleged irregularities. The obvious solution would be to credit a sum equal to the loss suffered into the respective funds' assets. It may not be a bad idea for the AMC to go the extra mile, and consider issuing bonus units to all investors in affected funds.

At times in the world of investments, perception is as important as reality itself. No responsible AMC can afford to be perceived as having a cavalier attitude when it comes to investors' monies or dealing with irregularities. Hence, now is the time for HDFC AMC to stand up and be counted!

Should SEBI be so concerned about size?

Admittedly, “does size matter?” is one of the more tricky questions to answer. Depending on where and when that question is posed, it could evoke different responses from the same individual.

However (and on a more serious note), market regulator SEBI seems to have an unambiguous view on the subject. It is seemingly convinced that bigger is indeed better. Not too long ago, it mandated that the minimum net worth of asset management companies (AMCs) be increased to Rs 500 million (from the erstwhile minimum of Rs 100 million). If recent media reports are to be believed, SEBI has written to AMCs asking them to merge or close debt funds with an asset size of less than Rs 200 million. Reports further suggest that equity funds with an asset size of less than Rs 100 million will be dealt with likewise.

Yet again SEBI seems convinced that investors’ interests will be better served by investing in larger funds. To be fair, larger funds offer certain advantages: all things being equal, they are structured to be more competitive on the price (read expense ratio) front versus smaller sized funds. In certain segments of the debt market, the minimum lot size is on the higher side, in turn necessitating that the fund have a reasonable asset size to be able to operate efficiently.    

But doesn’t it strike as being odd that the market regulator is now even dictating what a fund’s minimum asset size should be? Clearly, there’s more to it than meets the eye. For some time now, SEBI has been trying to make mutual fund investing less complicated for investors. Remember the risk-based colour-coding for funds, or even asking AMCs to disclose fund performance versus an appropriate benchmark index across specified time periods. To my mind, SEBI recognizes that there are too many funds available out there which makes fund selection a difficult task for investors. With this move, SEBI is in fact trying to rationalize the number of funds.

In India, AMCs have displayed a penchant for recklessly launching new fund offers (NFOs), since NFOs do act as tools of asset mobilisation. In this context, while the regulator’s intent cannot be flawed, the approach needs to be questioned. A fund’s asset size in isolation cannot be the barometer of its worthiness. Just as there are several small funds which perform and serve investors well, there are several large ones which are laggards and hurt investors’ interests.

Disallowing smaller funds en masse hardly seems like the right solution. Instead what the regulator must do is force (since they seem incapable of doing so voluntarily) accountability on AMCs. And here’s how:

1.   Make AMCs invest in all their open-ended funds:   

Extend the scope of the recent regulation whereby the concept of seed capital in open-ended NFOs has been introduced to all open-ended funds. Simply put, it should be mandatory for AMCs to invest their personal monies in all their open-ended funds. Apart from boosting the fund’s asset size, this move will (more importantly) also reveal an AMC’s true commitment to its funds. It should come as no surprise if a number of funds are voluntarily closed or merged irrespective of their asset size.

2.   Make the Board of Trustees accountable

The Board of Trustees (BoT) is required to sign off on NFOs authenticating that they are different from the AMC’s existing funds. Truth be told, not all boards have distinguished themselves, else we wouldn’t have had a proliferation of like NFOs. It’s time SEBI makes the BoT accountable by getting them to audit all existing funds on an ongoing basis with a view to weed out both weak and similar funds. The audit report, recommendations made and action taken should be a part of the annual statutory disclosure.

3.   Enhance quality of distributors

This is admittedly a long-term initiative: the Indian mutual fund industry needs more informed and better-equipped distributors. Sadly, there are a large number of well-meaning distributors who would like to do what’s right for the investor, but are ill-equipped to do so. For instance, when an AMC offers them a fund with a poor investment proposition, they are unable to see through it. The answer lies in re-visiting the criteria for empanelling distributors. Also, SEBI should mandate that a part of the monies meant for ‘investor education’ initiatives (we all know how that is really utilised J) be used for training distributors.

Finally, the market regulator must recognize that if it wishes to attract investors and build investor confidence, there is a need to make systemic changes in the mutual fund industry. Targeting smaller sized funds is unlikely to help on either count.

SEBI misses a trick or two

In its February 2014 board meeting, the market regulator approved a ‘Long Term Policy for Mutual Funds in India’. The policy has both tax and non-tax related proposals. Some of the latter are particularly interesting. For instance, there is a proposal to introduce the concept of seed capital whereby asset management companies (AMCs) will invest 1% of the amount raised (capped at Rs 5 million) in any open-ended fund they launch. Clearly the regulator wants to ensure that AMCs eat their own cooking which is a positive. Such a move can incentivize AMCs to put in due effort while running a fund since they will have skin in the game. More importantly in the larger scheme of things, it can help build investor confidence.

That in turn makes one wonder, why restrict a step which has the potential to be a game changer to just new fund offers (NFOs). How about existing funds which are open to investors for subscription; would it not be fair for AMCs to display the same commitment to existing funds. Make no mistake; there are quite a few funds out there which AMCs have conveniently lost interest in. Several of these funds were in vogue at the time of launch. However over time, their weak investment propositions have caught up leading to poor performance and dwindling assets. Should fund houses be forced to invest in their open-ended funds across the board, it will make for some interesting watching. It should come as no surprise if AMCs merge and close a record number of funds to circumvent the regulation.

And while we are on the topic, how about asking portfolio managers to disclose their investments in funds they run. In effect, while AMCs mandatorily invest in all their open-ended funds, managers are only required to disclose their investments (if any) in funds they helm. Wouldn’t these two steps go a long way in reinforcing investor confidence?

Another proposal suggests that the minimum net worth of AMCs be increased to Rs 500 million (from Rs 100 million at present). This one has been in the news for a while. Apparently the thinking is that increasing the net worth threshold is a surefire way to ensure that only ‘serious’ players operate in the mutual fund business. Mildly put, this rationale is ludicrous. A ‘large’ AMC doesn’t necessarily become better or even more investor-friendly than a ‘small’ AMC. While the importance of having serious players cannot be disputed, suggesting that an entity which can put together substantial monies automatically qualifies as one is inane. Let’s not forget that mutual funds operate as ‘pass-through’ structures; simply put, AMCs charge a fee and manage monies on behalf of investors who in turn enjoy/incur the profits/losses made. AMCs are certainly not expected to take losses on their books, thereby necessitating a higher net worth.

Furthermore if history is any indicator not all ‘large’ AMCs have distinguished themselves. Let’s not forget that some of them were among the worst offenders when it came to launching trendy NFOs (in rising markets) and transferring illiquid fixed income securities from debt funds to equity funds (during the 2008 meltdown). On the other hand, a ‘small’ AMC was the first to launch direct-to-investor funds thereby reducing the cost of investment for investors.

This regulation could well turn the Indian mutual fund industry into a big boys’ club, which is certainly not desirable. While SEBI must take all steps to ensure that ‘fly-by-night’ operators don’t enter the mutual fund business, it should certainly not elbow out niche players. Eliminating potential competition from smaller players with a differentiated offering might result in hurting investors’ interest rather than protecting it.

Don’t get me wrong. I’m not a SEBI-basher. If anything, I have by and large favoured most regulations instituted by the market regulator to protect investors’ interests. However this time around, SEBI has missed a trick or two: While the market regulator has failed to do enough in its proposal to introduce seed capital for mutual funds, the regulation to increase net worth for AMCs is a case of misguided righteousness.