Mutual fund IPOs? Beware!

Sudip Gupta is a manager in a consultancy firm with investible surpluses every month. But he is not even considering the mutual fund option for now.

The reason for his caution: in the last one year he has burnt his fingers more often than he has made money.

"I got taken in by the number of at-par mutual fund initial public offerings (Rs 10). I withdrew money from existing schemes and invested it in new ones. In the bargain I ended up removing money from funds with a good track record of performance to invest in schemes which have yet to 'perform.'

Gupta claims to understand the mutual fund business but still ended up making mistakes in his zeal to make money. "I am not the only 'educated' one in my office to have made this mistake and shudder to think what people who don't understand mutual funds do."

Some top fund managers in the industry agree that investing in IPOs just because they are being sold 'at par' is not the correct strategy.

The investor must look at whether the new product is needed for his portfolio. Most fund managers -- speaking on condition of anonymity -- agree that the spate of IPOs may end up doing more harm than good in the long term.

But they can't seem to resist the short -term favourable climate for mobilising assets. Thus, while on one hand mutual funds are trying to 'educate' investors on prudent investing, on the other they are busy selling IPOs hoping the investor is not educated enough to take a wise decision.

Says Ved Prakash Chaturvedi, managing director at Tata Mutual Fund: "The Indian equity markets and the mutual fund industry are passing through a phase where investors seem to have a significant appetite for IPOs."

"The markets have gone up significantly and investors mentally feel that entering a fund at Rs10 is preferable to buying funds at net asset values (NAVs) which are higher than Rs 10. Another point that needs to be made is that the Indian mutual fund industry has been restricted to few product themes in the equity fund category," says Chaturvedi.

"If you look at the global markets, typically there are a number of segments and sub-segments in the equity mutual fund space. This will happen in India too going forward.

What we see now is the beginning of that trend. As an economy matures, and as investor sophistication increases, product proliferation becomes a corollary," he adds.

Saurabh Sonthalia, head of strategy and business development at DSP Merrill Lynch MF, says: "IPOs have done well because such launches involve a focused effort and become a talking point for the sales force to go out and sell the new scheme."

"Secondly, IPO launches are usually backed by heavy advertising and marketing spends, which are otherwise not undertaken during the normal course of the year. Lastly, the age-old mentality of investors with regard to IPOs still persists. They believe they are purchasing units at a par value of Rs 10, whereas in reality the cash collected will, in a rising market, only buy assets at a higher price compared to a scheme launched much earlier," says Sonthalia.

The NAV of a mutual fund unit is actually irrelevant, as it is only an arithmetical number representing the latest market value of the portfolio divided by the number of units outstanding.

Investors have not yet fully understood the importance of a consistent, top-quartile track record, which a new scheme lacks, instead paying more attention to its supposedly 'lower' price.

Sonthalia adds that he is not totally against the idea of IPOs, providing they add to the breadth and range of products available to the end consumer, and enhance the portfolio of schemes offered by the mutual fund house.

"However, we are against the introduction of so-called new schemes which are nothing but a repackaging of the investment objectives of existing schemes, creating duplication within the same fund house and often used as marketing gimmicks."

Ajay Bagga, CEO at Kotak Mutual Fund, says it is a simple case of investors using the wrong analogy. "Investors fail to distinguish between stocks/shares and mutual fund units. Investors seem to believe that in value terms a Rs 10 unit in an IPO is better than existing schemes' units at higher NAVs - which is not the case, since that value depends not on the NAV but on the underlying stocks."

Like Sonthalia, Bagga feels that the high media spends undertaken by mutual funds during IPOs tends to create better pull for the product. Distributors are better incentivised to sell new products during their IPOs than they are to sell existing schemes.

Hence, the 'push' is also far higher. Also, mutual funds have entered a vicious circle, where, to prevent any erosion in their retail investor base, they have to launch new schemes.

In an IPO, the sales machinery of the MF and its distributors are geared towards selling the maximum in a minimum period of time. This typically helps build size faster and quicker.

In the drive to increase assets under management (AUM), this can be a very powerful invigorator.

Distributors will typically tend to sell what sells. Also, since the focus of the MF is on building asset size through aggressive means, the distributor can drum up volumes at a higher margin than what he would do conventionally, market sources said.

Sanjay Sachdev, CEO at Principal MF, says: "For distributors, it may be an easier sale as the investor is already predisposed to subscribing to IPOs. There is the perishability angle to an IPO - if I don't buy this before so and so date I cannot get it at Rs 10. In an ongoing scheme this pressure is not there on the investor."

While it has worked for AMCs so far, the worrying fact is that money has started getting churned extensively between schemes. The long-term impact, however, may be negative.

Clearly, many investors are paying higher prices (through multiple loads) and earning less as they churn their money across new and old funds.

MFs too lose out by not having steady, long-term money remaining in funds - the volatility of flows makes fund management far more challenging.

The long-term impact of this churning can result in lower returns to investors and lower investor confidence in mutual funds (due to lower returns).

Investor education is clearly the remedy to this situation. Only a well-informed investor would be able to make the right choice based on his/her financial plan.