Assets under costly (mis)management?
Sometime in 2005, policy managers had set out to fix few problems which were festering in the local fund management business.
By K Muthukumar & Shaji Vikraman , TNN |
MUMBAI: Sometime in 2005, policy managers had set out to fix few problems which were festering in the local fund management business.
A few issues were then addressed such as the practice of fund houses to spread the scheme expenses over a few years, which hurt the smaller guys who stay the course. Other incremental changes in rules have followed. But for an industry which now manages assets of over Rs 3,59,000 crore and hopes to add more numbers, the worry lines ought to be visible on the brows of policy makers.
For good reasons. In its marketing exuberance as well as the jousting for top dog status in the industry sweepstakes, some fund houses are now skating on thin ice—the dividing line between what is legitimate and what is a clever reading of the rules.
Consider dividends. Dividend rates are often used as tools to missell. If you are a mutual fund investor, it is not uncommon to find your agent sending an SMS “Gungho fund declaring dividend at 150%, hurry record date just five days away”.
It actually gives the impression that as an investor you are a loser if you do not invest in this fund. But that’s not the case as dividends are paid only out of its own net-asset value (NAV). The higher the dividend pay out, the fund’s NAV under consideration is bound to fall to that extent.
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In another interesting case, a mutual fund declared dividends on its equity fund. The extent of dividend declared would have made its investors exult with joy. The fund declared Rs 151 worth of dividend per unit in one year. But then the dividend wasn’t paid out of returns earned during the year. It was actually paid out of past returns which is evident from the way the fund’s NAV shrunk. The best part was that these dividends were declared in a growth option scheme. At the time of investing, investors have the option of either dividend or growth. An investor who chooses the dividend option is seeking cash flows at regular intervals and would like his fund managers to book profits.
Growth option investors are different in that they want to stay invested at all time seeking no dividends. Yet, the fund under consideration ended up paying dividends to its growth investors. It’s a mystery as to why this was done. Of course, its website mentions that the dividend declaration is at the discretion of the trustee.
One of the foreign banks operating here is reportedly celebrating, as 2007 was a special year marked by record fees. A mutual fund distributor hints that the bank’s fees for the year was close to Rs 200 crore. Some of its relationship managers managed to convince its private banking clients to churn its mutual fund portfolio several times over.
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This helped them reap good brokerage fees. It is typical for a relationship manager to intimate clients about how their investment have appreciated ever since he invested. (In the bull run, even a dud would have done so). This is usually followed by recommendations to now ‘book profits’ and invest it in another new fund offering (NFO). NFOs usually earn commissions of up to 5% and churning mutual fund portfolio is the best way to earn them.In the past, distributors had a ball selling (misselling) NFOs. Equity NFO collections were at an all-time high at Rs 36,000 crore in 2006. Sebi thankfully put an end to this by capping initial issue expenses. In the past, mutual funds were allowed to charge the scheme up to 6% of overall NFO collections.
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This is done in the form of amortisation over a period of years. This led to rampant marketing and high distribution commissions since it was ultimately the investors who bore such expenses. Thereafter, Sebi unveiled regulations that made it mandatory for all open-ended schemes to meet marketing and expenses connected with sales and distribution out of the entry load and not through initial issue expenses. In 2007, equity NFO collections roughly fell by half of that of the previous year.
Tests
Sebi has been trying to improve the distribution standards in the country. Five years ago the regulator made it compulsory for distributions to pass a test while granting more time for existing distributors to clear the test. One of the accusations is that the test lacks rigor.
In fact, in the US there are various tests considered to be tough, which even chief investment officers and distributors have to sit for. This is very important, at least for top notch executives since it not only ensures proper distribution but also fund managers with proven expertise in investment management.
Some instances cited above raised questions relating to the oversight role of the board of trustees of fund houses. As a former SEC chairman termed it, trustees are the first line of defence or regulation for ordinary investors. They have a fiduciary relationship.
While there has not been any major blow up recently, holes are clearly visible. Seldom has there been a case of the trustees stepping in to curb some of the abuses that the fund managers have indulged in.
Way back in 2003, following a scandal in the mutual fund industry, the US put in place a legislation for greater oversight of the industry, disclosures of fees and costs. Trustees there now need to carry out an a annual self-evaluation of the effectiveness of the board.
Expense ratios
With the local pension sector about to open up, it is disturbing to see that mutual fund expense ratios are among the highest. Most of the equity funds today charge the maximum fees. This could go as high as 2.5% annually. This is despite equity assets more than doubling in the last three years.
In the US, equity funds typically have expense ratio of 1.1%, which includes the front load fees. This has fallen from an average of 2.3% which existed in the 1980s. Ever since it has only been sliding. Ideally, the expense ratio need to fall from economies of scale but at the moment the asset management companies doesn’t feel the need to reduce the charges.
This despite the fact that it has been close to 14 years since the first private sector mutual fund set up operations in the country.
Indian fund houses have taken the easy way out on the distribution front given the costs and time involved in building a pan-India network. But that is where ultimately the growth will come from. In the insurance industry, the regulator has made it mandatory for a part of the incremental business to be written only from the hinterland.
Such diktats exist in several sectors, including telecom, airlines and banking. Has the time come for asset management houses to be told to diffuse the concentration on metros? According to industry data, at least 80% of assets under management are accounted for by investors residing in the top eight cities of the country.
The health of the industry and the practices adopted by it are vital in the context of pension money coming into the markets. Abuses by the industry can hurt the opening up process.
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