Prashant Jain Quits… An Era Ends

In my nearly twenty-year tenure as a research professional, I have witnessed a host of changes in the mutual fund industry. However, among the few constants has been the presence of Prashant Jain at HDFC Mutual Fund. Jain likely holds the record for the longest manager tenure at the helm of an Indian fund. His exit from HDFC Mutual Fund came as a surprise. 

Despite his constancy, in recent times, Jain emerged as a polarizing figure in the industry. While many believed that he was past his prime, others had steadfast faith in his abilities. And for those who came in late, it was hard to figure out what the fuss about Prashant Jain was.

His research-driven investment approach, valuation consciousness, contrarian bent, and laser-like focus on the long-term, are well-documented. However, Jain will likely be best remembered for his willingness to stick to his conviction. 

Jain was willing to endure long periods of underperformance in pursuit of his conviction. When the latter paid-off, his funds would stage spectacular comebacks. Turnarounds like the ones in 2003, 2009, and 2014, cemented his position as first among equals, in the pantheon of portfolio managers.

Then again, conviction can be a double-edged sword. Admittedly, the last few years have been difficult. From 2017 through 2020, Jain’s funds delivered an indifferent showing. Their asset sizes shrunk, and risk-profiles worsened. As the sheen wore off, expectedly both Jain and his funds were severely panned by the mutual fund ecosystem.

And just when he was all but written off, Jain staged yet another comeback of sorts in 2021. Near-term showing suggests that his funds are topping their respective categories.

But there’s more to Jain’s portfolio manager credentials. 

An integral part of researching and rating mutual funds is expressing an unambiguous opinion. Sadly, a large number of portfolio managers are less-than adept at handling unfavorable views. Jain was an exception. He was always respectful of the analyst’s right to express critical views, even if he disagreed with them.

Jain’s conviction in his investment approach also shone through his personal investments. Even when it wasn’t mandatory to invest in or disclose manager investments, Jain invested millions of his personal monies in funds he ran.

Manager meetings are essential to fund research. Unlike some of his peers, Jain never had ‘no-go’ areas for interactions. 

Oddly my last interaction with Jain was some time ago when I bumped into him at an airport. Though we hadn’t met in years, Jain was quick to exchange pleasantries. He came across as the same affable person I knew, optimistic about the future of equities as ever.

His recent struggles notwithstanding, Jain made a sterling contribution to the mutual fund industry by lending it immense credibility. His exit undeniably marks the end of an era.

Go well Prashant!

#PrashantJain, #HDFCMutualFund, #HDFC, #mutualfunds, #investing, #MutualFundsSahiHai

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.

Should Investors Fear Debt Funds Taking Credit Risk?

In October 2008, fixed maturity plans (FMPs) were in the news for all the wrong reasons. The financial crisis had set in, and equity markets had crashed.

Debt markets weren’t spared either: it was feared that papers issued by some real estate and broking firms, among others would default. Several debt funds, including FMPs were heavily invested in such instruments. Amidst tight liquidity, there was a run on fund companies, which in turn led to distress sales, and net asset values (NAVs) crashing. The latter fuelled more panic, and further distress sales.

Roughly nine years hence, I see a similar narrative playing out in the context of debt funds taking credit risk. Admittedly, the level of fear isn’t even remotely comparable as yet, but make no mistake, the narrative is similar.

Every time a credit rating agency downgrades the rating on an instrument, it makes headlines. Media lists which mutual fund portfolios hold the downgraded paper, alongside the allocation. Words such as default and loss are liberally tossed around, leading to fund investors hitting the panic button.

So should investors fear debt funds that take credit risk? Let’s find out.

The strategy of taking credit risk (or high-yield investing) entails investing 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 price appreciating if the credit rating is upgraded.

Does this investment strategy involve risk—indeed, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risk, should investors shun funds using a credit risk-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several portfolio managers (both in India and globally) have plied it successfully and delivered pleasing long-term results. A strategy doesn’t become faulty simply because it entails risk.

Some experts argue that investors should only invest in debt funds deploying the duration strategy. That’s a weak argument because failing to read the direction in which interest rates will move, can also lead to losses. A case in point is the performance of debt funds in February 2017, when contrary to expectations, RBI kept policy rates unchanged.

Also, this is a case example of missing the woods for the trees—mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent.

Investors will do themselves a huge disservice by treating debt funds with a credit strategy like pariahs, and hitting the panic button in reaction to every news story. Instead, a prudent approach will be to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

It's worth noting that when investment decisions are based on a combination of fear and ignorance, the results can be rather unpleasant.

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.

Rate Cuts, Expert Speak, and Investment Advice

Last week, the Reserve Bank of India (RBI) in its bi-monthly monetary policy review kept the benchmark repo rate unchanged. The move surprised markets which were expecting a rate cut of at least 25 basis points. The consensus was that liquidity in the banking system would improve thanks to demonetisation. This coupled with benign inflation would give RBI leeway to cut rates. 

In the weeks leading up to the monetary policy review, investment experts in media were urging investors to capitalize on the foretold rate cut. Their advice was unambiguous: invest in long-term bond and gilt mutual funds to make the most of the opportunity.

However, RBI’s decision to leave policy rates unchanged meant that bond yields rose sharply. The performance of mutual funds positioned on the longer end of the yield curve took a hit.

Interestingly, experts’ narrative changed overnight. Several experts who were espousing the cause of long-term bond and gilt funds did a volte-face; now the advice was to invest in short-term bond funds.

Let’s consider the case of an investor who relied on the aforementioned experts while investing. Swayed by the flurry of advice centred on rate cuts, he allocates a substantial portion of his portfolio to long-term bond and gilt funds. Expectedly, his portfolio suffers. Subsequently, he is told that short-term bond funds are a better bet. The investor clearly finds himself in an unenviable position.

To clarify such instances are far more common than one imagines. While this time around the event was an expected rate cut, in the past too, experts have been known to dish out advice, anticipating outcomes of events such as elections, political referendums, and union budgets.

Investors who rely on expert speak while investing have a simple rationale: an individual is being quoted in a newspaper or, making a television appearance, because he is an expert. So acting on his opinion is the right thing to do. Sounds reasonable, doesn't it?

Sadly, this line of thought isn’t correct. To understand why, one must understand what investment advice is.

To qualify as investment advice, apart from being accurate, the counsel needs to be customised for the investor. In other words, the investor’s risk appetite, investment horizon, financial goals need to be taken into account. That’s never the case with media quotes by experts, which are at best generic opinions.

Furthermore, often investors are prodded to invest tactically. For instance, in this case, for the ‘advice’ to play out successfully, an event—rate cut—had to occur. Investment strategies whose success hinges on an event such as election results, change in government policy, quarterly results of a company tend to be riskier than those which bank on fundamental reasons such as a macroeconomic turnaround, a company’s robust business model. Simply put, tactical investing is apt for a risk-taking investor.

Another integral aspect is the allocation made. Ideally, a tactical investment should be an ancillary holding (as opposed to a core holding) in the portfolio.

However, such nuances are never (and perhaps cannot be) communicated in a published article or a television appearance.

Hence it is important for investors to appreciate that there is a fundamental difference between investment advice and expert speak in the media.

Investors who need assistance would do well to source the same from a competent and independent adviser. While expert speak in the media can be a source for information, treating it as investment advice can result in unsuitable investments, and failure to meet financial goals.

Investment Lessons from ‘The Godfather’

For film buffs and critics alike, ‘The Godfather’ embodies what celluloid magic is all about. Over four decades after its release, the movie continues to capture the imagination of audiences like no other, reaffirming its status as a classic.

But there's a lesser-known aspect of 'The Godfather'. Apart from being a source of inspiration to aspiring actors and filmmakers, the film has a lot to offer to investors as well. Following are investment lessons from ‘The Godfather’:

Barzini is dead. So is Phillip Tattaglia, Moe Greene, Stracci, Cuneo. Today I settled all family business

A laser-like focus on objectives and ruthless discipline in their pursuit, are defining traits of Michael Corleone’s personality. Be it protecting his family or safeguarding his business interests, Michael is decidedly aware of his goals and will do whatever it takes—sacrifice his career in the armed forces, join the ‘family business’ and even eliminate his rivals—to achieve his goals.

Similarly, investors would do well to set goals before they start investing. Goals can range from near-term ones such as creating a holiday budget, to long-term goals like a retirement kitty. Apart from making investing focussed, setting goals also helps in tracking progress. Thereby deviations (if any) can be easily rectified. Furthermore, being disciplined (read: curtailing wasteful expenditure, and investing regularly in line with a plan) will help investors stay on course to achieve their goals.

Some people will pay a lot of money for that information; but then your daughter would lose a father, instead of gaining a husband

Michael, a fugitive on the run in Sicily, is enamoured by a local girl. When confronted by her indignant father, Michael calmly reveals his true identity. Also, he lays out the options available, and the trade-off therein.

Likewise, while investing in market-linked instruments, investors must be unambiguously aware of the risk-return trade-off. For instance, a small-cap stock can deliver substantially higher return versus a large-cap stock; however, the potential upside comes at a price—higher risk, if the investment doesn’t play out as expected. Similarly, sector-focused mutual funds can outperform diversified funds, but they expose investors to higher risk. Hence investors must accurately understand the risk-return trade-off before making an investment decision.

Where does it say that you can't kill a cop?

When the Corleone family is under attack, Michael comes up with a seemingly outlandish plan that includes killing a corrupt police officer. His sound rationale wins over his sceptical associates. Essentially, Michaels’s willingness to think out-of-the-box wins the day.

At times, investors can be guilty of being orthodox in their choice of investment avenues. For example, some invest only in bank fixed deposits and small savings schemes because of habit rather than choice. By refusing to consider other apt options, investors run the risk of not meeting their investment goals.

For instance, an investor in his twenties who is saving for retirement 30 years hence, shouldn’t hold a portfolio comprised of only fixed deposits and bonds. Equities and mutual funds must find place therein. Remember, risk in itself isn't bad; rather, investing without being aware of it, and/or failing to correctly assess it, gives rise to thorny situations.

It's not personal. It's strictly business

Every character quoting this legendary line tries to convey that a given action should be seen as a business decision i.e. in a dispassionate manner. In other words, it has nothing to do with personal feelings. The 'not personal' part holds good for investments as well.

At times, investors get 'attached' to their investments. This is especially true of stocks and mutual funds that have had a successful run. The trouble starts when the investment avenue is no longer equipped to perform as it has in the past. Then there are misguided investments which fail to deliver, but investors hold onto them, hoping to ‘get even’.

This approach to investing is unwarranted. An investment is simply a means to an end i.e. the investment objective. If a thorough evaluation suggests that the investment is no longer equipped to play the part that it was supposed to, investors must salvage the situation by exiting the investment at an opportune price and time.

Tom Hagen is no longer consiglieri 

While expanding his operations, Michael sacks his adoptive brother/long-time associate, Tom Hagen from the post of consiglieri (adviser). Stating that Tom isn’t a wartime consiglieri, Michael replaces him with someone adept at strong-arm tactics, since the situation demands it.

Barring a small section of investors who can manage their own investments, others need assistance in the form of investment advice. Investors have a variety of options—distributors, advisers, robo-advisory firms—to choose from. Quality of investment advice can and does have a bearing on investment results. Hence, investors must perform rigorous due-diligence before engaging an adviser. Also, there is a case for reviewing the adviser’s performance at regular time intervals.

I'll make him an offer he can't refuse

In Godfather parlance, this iconic line represents a veiled threat. Refusal to comply with the offer can lead to dire consequences.

In the world of investments, there are periods when markets are frothy and irrational exuberance is the order of the day. In such periods, it is not uncommon for investors to encounter investment propositions that claim to offer a win-win proposition. For instance, an investment that offers high return with virtually no downside. That’s when investors must remember that if the 'offer' sounds too good to be true, then it probably is.

Should Investors Tap Into Media For Investment Advice?

Last weekend at a party, I met a rather interesting individual who declared that ‘the best things in life are free’. To buttress his view, he spoke about investments, and questioned the need to engage an adviser (read pay a fee), when one can get free advice from the media i.e. publications and television channels. I’m unaware as to what drove his belief: experience or the lure of ‘free’. In any case, his views found several takers, and soon he was dishing out ‘free advice’ on the best sources of investment advice. 

To be honest, this isn’t the first time I have heard such views being expressed. Many investors are convinced that sourcing and acting on investment advice from media can be financially rewarding. But is that line of thinking prudent? Let’s find out.

Advice vs. Coverage

Any adviser worth his salt will agree that investment advice should be focused on the investor i.e. customised to his risk appetite, investment horizon and goals. The key is to navigate the investor’s portfolio through various events, and stay on course to achieve predetermined goals.

Conversely, the media typically focuses on current events and trends. The journalist/host will have a perspective in place. Domain experts contribute to the perspective with quotes and/or data. Having covered one event, the media moves on to the next.

Whether or not the coverage is apt for every investor following it, is anyone’s guess. Therein lies the fundamental difference between investment advice and media coverage.

Go Where the Wind Blows

In Feb 2016, when domestic equity markets crashed, stocks of public sector banks were among the worst hit, reeling under burgeoning bad loans. Expectedly the media coverage was negative, and most experts opined that the worst was far from over.

Between then and now, both bank stocks and equity markets have staged a smart recovery. While fundamentally not much has changed, appreciating stock prices have resulted in sections of the media putting a positive spin on PSU bank stocks with experts stating “You can’t do away with SBI. If it’s not in our portfolio, we are missing out on India’s economic growth…” and so on. To clarify, such instances of rapidly changing positions are common in media.

Is this a case of mala fide intent? Not at all. This is simply the nature of the beast; media covers events in a manner that will appeal to its audience. Investors choosing to treat media coverage as investment advice, and acting on the same, only have themselves to blame.

Should We Shoot The Messenger?

Does the solution lie in insulating oneself from media? I don’t think so. Media can be an excellent source of information and updates. Following reputed channels and publications can help stay abreast of events. That’s where investors must draw the line.

I’m not suggesting that every investor must engage an adviser. There are several who are conversant with the nuances of investing, and don’t need to engage an expert.

As for investors who need assistance, but have never paid for investment advice, admittedly it can be a difficult threshold to cross. But there’s a need to weigh up the downside of a misguided investment versus the cost of acquiring prudent and expert investment advice. 

In any case, relying on media for investment advice seems like an imprudent choice.

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 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

Don’t let the tax bogey affect your mutual fund investments

It’s official. The Finance Ministry has clarified its stance on taxation for non-equity mutual funds regarding the ‘retrospective’ aspect. Also, it is evident that there will be no rollback in other proposals; Finance Bill 2014 has been passed by the Lok Sabha and is now awaiting a nod from the Rajya Sabha. For all intents and purposes, fixed maturity plans (FMPs) have lost the tax advantage they enjoyed over fixed deposits (FDs), and now debt fund investors must have an investment horizon of at least 36 months if they wish to reap tax benefits on long-term capital gains.   

An interesting outcome of this development has been in the form of investment advice. Experts are falling over each other trying to determine which investment avenue is best suited for individuals in specific tax brackets. For instance, statements such as “if you are in the lowest tax bracket then FDs make sense, however for those in the highest tax bracket, long-term debt funds will be the best bet” have become commonplace. Fund houses seem to have been caught up in the frenzy as well. Media reports suggest that some of them are trying to extend/roll over one-year FMPs for a further 24-month period so that investments therein will become eligible for long-term capital gains.

The trouble with this tax-focused muddle is that it contravenes the basic principles of investing. Don’t get me wrong—I’m not suggesting that tax implications should be ignored; however, they certainly shouldn't be the primary basis for making an investment. For instance, a fundamental difference between FDs and debt funds (including FMPs) is that the former offer safety of capital and assured returns, while the latter are market-linked investments i.e. the capital invested is at risk, and there are no assured returns. It is imperative that investors first get a fix on what their risk profile is, and accordingly pick an investment avenue, rather than start off by evaluating which avenue is more tax-efficient.

Likewise, the investment horizon is no less important. Consider a scenario wherein an investor in the highest tax bracket has surplus monies to put away for 18 months. It would not be prudent to invest in a 3-year FMP only because the taxation thereon is more liberal versus that on an 18-month FD. Simply put, investors must focus on aspects such as risk profile and investment horizon, before considering the investment’s tax-efficiency. Failing to do so could result in investors deploying monies in avenues unsuitable for them, and for inapt tenures as well.   

Arbitrage funds to the rescue…

If the aforementioned experts are to be believed, debt funds have lost their appeal for good, and now investors should focus on a new silver bullet—arbitrage funds. Sadly that argument is both preposterous and flawed.

Arbitrage funds operate on the premise of exploiting mispricing opportunities between the cash and derivatives markets. They thrive on market volatility. At its core, it is a straitjacketed approach since it will only deliver in certain market conditions. Furthermore, unlike debt funds which invest in fixed income securities, arbitrage funds operate in the domain of equities—so much for their likeness. If you are wondering why arbitrage funds exist in the first place—the answer is herd mentality. In the NFO-driven era of 2005-06 when a couple of fund houses launched arbitrage funds, others followed suit lest they be left behind. Like most NFOs, the launch of arbitrage funds had little to do with conviction in investment merit.  

So why have arbitrage emerged as the season’s flavour? Because they are treated as equity funds for taxation (read liberal tax rates and provisions) while plying a market-neutral strategy. On their part, investors would do well to steer clear of experts who profess that arbitrage funds make apt replacements for debt funds. 

Admittedly, a higher tax liability on debt fund investments is taxing both literally and figuratively. But trying to circumvent it by investing in unsuitable avenues will only make matters worse. The solution lies in coming to terms with the new scenario and staying the course.

Of exit loads, fund houses and distributors - 2

Yesterday...
All my troubles seemed so far away,
Now it looks as though they're here to stay,
Oh, I believe in yesterday...

(Yesterday – The Beatles)

This iconic song pretty much sums up the mood among several mutual fund distributors. For distributors habituated to attractive compensation structures and easy money, the new-look mutual fund industry has come as a rude shock. In one deft move (scrapping entry loads), the regulator changed the rules of the game. Further, the provision for uniform exit loads plugged the loophole that some would have liked to exploit.

Newspaper reports suggest that fund houses’ pleas to roll back/modify the entry load provision has been rejected by SEBI. Some fund houses have decided to compensate distributors by paying them an upfront commission in any case. Distributors on their part are tweaking their business models. Fee structures are being charted out; new value-add offerings are being introduced. Terms like ‘unbiased’, ‘independent’ and ‘research-driven’ are now liberally used in communication. Clearly, the mutual fund industry is in unchartered territory and ‘wait and watch’ is the new mantra.

Despite the gloomy picture being painted by most, it would be safe to state that the scenario isn’t as bad as it is made out to be. In fact, things could become markedly better for all the participants i.e. investors, fund houses and distributors.

Conventionally, distributors have worked on the ‘assets under management’ model i.e. more investments their investors made, higher was their pay-off. Broadly speaking, the latter came from the entry load, the trail commission and ancillary compensation/benefits provided by fund houses. While entry loads have been done away with, distributors can now demand compensation from investors directly. Also, unlike loads, this compensation is not regulated. It has been left to be mutually determined by the investor and the distributor.

Distributors argue that investors are unlikely to be willing to compensate them. There is some merit in that argument. Investors habituated to filling mutual fund forms and writing cheques for the investment amount, might resist the new arrangement initially. However, once they are convinced of the value that the distributor adds to the investment process, the resistance will subside.

The importance of quality advice and service cannot be overstated. The distributor has a vital role to play in aiding the investor achieve his financial goals. Making an investment plan, successfully managing and tracking an investment portfolio are no mean tasks. And once the distributor effectively communicates how his services can aid the investor, there’s no reason for the investor not to come on board.

Sure, distributors who fail to add value and work in the investor’s best interests might see their business dwindle. But that would only be a fair and natural consequence.

From the fund houses’ perspective, it’s an opportunity to have access to serious, long-term money. It isn’t entirely uncommon to see ill-advised investors invest monies simply to ride the rising markets. With quality advice being made available to investors, we could see the rise of a breed of informed investors who are willing to stay invested for the long-haul. Investors who don’t panic when markets experience downturns; instead they see the same as an opportunity to make investments at attractive prices. Now wouldn’t fund houses love to have such investors investing in their funds? Also, it would be fair to assume that fund houses will handsomely compensate distributors facilitating serious investors and long-term monies, for their efforts.

As for the investor, it's options galore. Some distributors will operate on the ‘transaction’ model i.e. use technology to offer investors a low-cost platform for making investments, others will bank on providing quality advice and then there will be those whose USP will be personalised service. In most cases, there will be an overlap. From the investor’s perspective, the importance of being aligned with the right distributor has never been higher. Investors will have to thoroughly evaluate the proposition offered by each distributor and select the one that best works for them.

For instance, if a distributor boasts of his research set-up, quiz him about the same, the size of his team and their experience. If a distributor claims to be independent, enquire how he ensures that his independence is not compromised with. If ‘low-cost investing’ is the platform on offer, find out how the same compares with other distributors. The onus to conduct a thorough due diligence and make an appropriate choice lies with the investor.

It won’t be surprising if investors choose to be associated with multiple distributors; for instance, the advice could be sourced from one distributor and transactions made with another.

As mentioned earlier, the mutual fund industry and its participants are in unchartered industry. However, despite what the naysayers would want you to believe, it need not be all gloomy. Remember the adage about – it’s not the cards you are dealt, but how you play them. The ‘how you play them’ part could hold the key for the mutual fund industry, going forward.

Here comes the sun,
Here comes the sun,
And I say it's all right,
Little darling, it's been a long cold lonely winter,
Little darling, it feels like years since it's been here,
Here comes the sun, here comes the sun,
And I say it's all right...

(Here comes the sun - The Beatles)

Of exit loads, fund houses and distributors - 1

The line, it is drawn, the curse, it is cast
The slow one now, will later be fast
As the present now, will later be past
The order is rapidly fading
And the first one now, will later be last
For the times, they are a changing

(The Times They Are A-Changin'- Bob Dylan)

To say that times are changing for the mutual fund industry would be stating the obvious. In all fairness, not many anticipated the same; perhaps, some are still struggling to come to terms with it. Nonetheless, change is here and it’s here to stay.

Retail investors, who have conventionally been at the receiving end of whims and fancies of fund houses and distributors alike, have become an empowered lot. Thanks to the regulator’s intervention, a level playing field has been created. Fund houses had barely recovered from the SEBI regulation abolishing entry loads, and now the regulator has taken aim at exit loads. SEBI has ruled that fund houses can no longer charge differential exit loads based on the investment amount.

First, let’s discuss what an exit load is. Simply put, it is a charge/penalty levied on an investor for exiting an investment before a stipulated period. For instance, open-ended equity funds may require investors to be invested for at least 12 months, in order to avoid paying an exit load. The rationale for the same is quite simple. Each fund has a distinct nature and it should attract monies for a commensurate time frame. Equity funds typically require investors to have a much longer investment horizon vis-a-vis say a liquid fund. Now an investor, who gets invested in an equity fund for a shorter time frame, might on exit, force the fund manager’s hand, and in the process hurt the prospects of long-term investors in the fund. Hence, the exit load which acts a deterrent for erring investors.

However, fund houses chose to tweak the exit load provision to accommodate big-ticket investors like high networth individuals (HNI) and corporates. This was done by creating differential exit loads based on the investment amount. For example, a retail investor investing Rs 5,000 was charged an exit load of 1.00% for liquidating his investment before 1 year from the date of investment; however, an HNI investing Rs 5 crores (Rs 50 million) in the same fund was outside the purview of exit loads. If you are wondering why fund houses perpetuated such disparity, the answer is pretty straightforward. A higher asset size equals higher revenue for the fund house. Typically, an HNI/corporate investor brings in a substantial amount of money i.e. he significantly contributes to the fund house’s asset size and revenues in turn. Hence, fund houses' willingness to ‘accommodate’ them.

There are some who justified differential entry and exit loads on the grounds that bulk transactions are subsidised in all walks of life. Sadly, the difference between buying grocery at a supermarket and investing in a mutual fund is lost on such individuals.

Thanks to SEBI, fund houses will now have to shed their prejudices and treat all investors alike going forward.

The reason for entry loads coming under focus at this stage is quite interesting. This phenomenon can be traced to the SEBI directive abolishing entry loads. Therein, the regulator had stated that 1.00% of the monies collected as exit loads can be utilised by fund houses to compensate distributors and meet marketing and distribution expenses.

Expectedly, fund houses saw an opportunity to aid distributors by implementing a stiffer exit load structure. The latter meant that either investors would pay higher exit loads or be required to stay invested for longer (vis-a-vis the past) to avoid paying an exit load.

Fund houses would like us to believe that the move to hike exit loads was only intended at promoting long-term investing. And perhaps it was. But then, isn’t it fair that all investors (irrespective of the investment size) be exposed to the virtues of long-term investing?

Had differential exit loads not been scrapped, the new (read stiffer) exit loads would have been borne by retail investors, since investments made by HNIs and corporates were largely outside the purview of exit loads in the earlier regime. SEBI has ensured that the exit load burden (and thereby the onus to indirectly compensate distributors) is equally borne by all investors.

Clearly, the excesses in the mutual fund industry were not lost on the regulator who has decided to champion the investor’s cause. The abolition of entry loads and differential exit loads are among several changes that will have a lasting impact on the mutual fund industry.

Any discussion on the mutual fund industry’s metamorphosis cannot be complete without deliberating on distributors. Over the years, the importance of distributors as a link between fund houses and investors, and more importantly as fund houses’ allies has grown by leaps and bounds. And now, the distribution mechanism is all set for a major overhaul as well. More on that in the concluding part of this article.

What happened to close-ended funds?

Circa 2006-07, close-ended funds were the season's flavour. Fund houses were busy convincing investors to get invested on the premise that close-ended funds furthered the cause of 'long-term' investing. Investors had a plethora of options to chose from since close-ended NFOs (new fund offers) of every conceivable kind were launched i.e. mid-cap, flexi-cap, thematic, fund of funds and tax-saving.

The genesis of close-ended funds
When equity markets hit a purple patch in 2003, fund houses capitalised on the same by launching equity fund NFOs. Most NFOs were of the open-ended variety. Fund houses were permitted to charge initial issue expenses (6% of corpus) to the fund and amortise the same over a period time. Initial issue expenses were largely used to meet marketing and distribution expenses. As a result, distributors were handsomely rewarded for their efforts in asset mobilisation.

A spanner in the works came in the form of a SEBI guideline that scrapped initial issue expenses on open-ended NFOs. Now, fund houses were required to meet NFO-related marketing and distribution expenses from the entry load; the norm was 2.25% of the sum invested. But close-ended NFOs were out of the purview of this ruling. While fund houses were permitted to charge initial issue expenses on close-ended NFOs, the trade-off was that they were prohibited from levying an entry load. The choice between initial issue expenses and entry load was a no-brainer. The result was a deluge of close-ended NFOs.

It would be unfair to paint all fund houses and close-ended NFOs with the same brush. Some close-ended NFOs did offer a truly innovative investment proposition. However, ignoring the marketing aspect would be naive.

The present scenario
It can be safely stated that close-ended funds are a forgotten breed now. Maybe, it had something to do with a subsequent guideline (January 2008), wherein SEBI decided that close-ended NFOs be treated on par with open-ended NFOs i.e. they would be permitted to charge an entry load and the provision to charge initial issue expenses was scrapped.

While close-ended funds may not feature on the priority lists of fund houses, it's a different scenario for investors. Several investors got invested in close-ended NFOs and continue to hold the same in their portfolios. Also, since then, markets have had quite a journey - an ascent to record highs, followed by a sharp downturn, and a recovery of sorts. It would be interesting to study how close-ended funds have fared so far.

The performance
Of the several close-ended funds launched in the 2006-08 period, 4 have a 3-Yr track record now. The following table shows how they have fared vis-à-vis comparable open-ended offerings from the same fund house and their respective benchmark indices.

	3-Yr (%)
Franklin India Prima	8.2
Franklin India Smaller Companies ©	6.6
CNX Midcap	16.8
HDFC Premier Multi-Cap	14.1
HDFC Long-term Equity ©	9.1
S&P CNX Nifty	15.2
ICICI Prudential Dynamic	18.2
ICICI Prudential Fusion ©	6.5
CNX Nifty Junior	18.7
Tata Tax Saving	12.6
Tata Tax Advantage 1 ©	14.3
BSE Sensex	14.6

(NAV and index data as on July 24, 2009. © indicates close-ended fund. NAV data sourced from www.amfiindia.com. Index data sourced from www.bseindia.com and www.nseindia.com. All data in CAGR terms)

As can be seen in the table above, close-ended funds have failed to match their benchmark indices over the 3-Yr period. Furthermore, with the exception of one fund, others have failed to match comparable open-ended funds from the same fund house. Even a cursory glance at performance of other close-ended funds (ones that have been in existence for less than 3-Yrs) will reveal that largely their performance is nothing to write home about.

It ain't over, till it's over
Critics might argue that the aforementioned funds need not be a representative sample of the entire close-ended funds category. Fair enough. But few would dispute that close-ended funds have failed to impress so far.

Fund houses are likely to justify the mediocre showing posted by close-ended funds on the grounds that these are early days. Given that most close-ended funds have a 5-Yr tenure, passing any judgement at this stage would be premature. Also, several funds have a provision for conversion into open-ended funds on maturity. Hence, should they fail to deliver in their close-ended avtaar, investors can continue to stay invested and exit the same at a more opportune time. While there might be some merit in the former argument (early days for funds), the latter certainly doesn't hold good.

Here's why - investments in close-ended funds were made on the premise that they would enable fund managers to make long-term investment decisions i.e. fund managers would not be weighed down by factors like redemption pressure and short-term market occurrences, that typically plague open-ended funds. When investors agreed to forsake liquidity (make a 5-Yr commitment) and bear initial issue expenses, the trade-off should have been a superlative performance. The least investors would expect is for close-ended funds to deliver a better showing than open-ended funds. And should close-ended funds fail to deliver, investors have every right to feel aggrieved.

What investors must do
Investors would do well to appreciate that not every promising proposition translates into a sound investment avenue. On paper, a close-ended fund with a defined maturity horizon and corpus sounds like an interesting idea; however, with the benefit of hindsight, it can be safely concluded that not every close-ended fund will live up to the promise. This underscores the importance of seeking diversification and a track record while making investment decisions.

Also, investors must keep track of their close-ended fund investments. Be patient and give them adequate time to prove themselves. Despite this, if they fail to deliver, don't hesitate to exit them after taking into account factors like the exit load. Perhaps an alternative fund with a similar investment proposition might be a better bet.