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Rediff.com  » Business » Buying mutual funds? Beware!

Buying mutual funds? Beware!

April 24, 2006 09:58 IST
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For most retail investors the title of this article will come as a surprise. After all, mutual funds, the equity-oriented ones in particular, have turned in a fantastic performance over the last three years.

And as it happens in all bull markets, you, the retail investor, are so overcome with the delight of having made quick money that you overlook the warning signs out there. Guess who is out there making the most of your 'greed' -- the unscrupulous mutual funds.

Until recently, the Asset Management Companies (AMCs) were having it very easy in mobilising monies by launching what is now called New Fund Offers (NFOs). The lure of the Rs 10 Net Asset Value (NAV) helping the cause (note how some of the AMC advertisements highlight this).

Of course, we all know, and this is an issue we have dealt with many a time on Personalfn, a Rs 10 NAV does not increase your chances of clocking a better return! Worse still, the initial issue expenses, sometimes as high as 6% of the initial mobilised amount, are borne by investors over five years, as the regulator, the Securities and Exchange Board of India (SEBI), until recently, permitted such amortisation.

So for argument's sake if the fund mobilised Rs 100 in an NFO, and Rs 30 got redeemed within an year (as in a lot of cases; most NFOs in 2005 were the result of a compulsion of distribution and nothing more), from the next year onwards, the overall amortised cost of Rs 6 (Rs 1.20 per year) will have to be distributed over the reduced AUM (Rs 70, assuming no new money comes in and markets remain unchanged), effectively making the cost to the initial unit holders who are still invested a lot more than 6%.

This makes it even more difficult for the fund manager to outperform the markets.

Thanks to SEBI, this practice of 'taking the investor for a ride' will not be viable anymore. As a fair disclosure, Personalfn, which offers personalised financial planning services, recommended no more than 7 of the over 70 NFOs to its clients which hit the market in the last 12 months. Needless to say, most AMCs did not think we will go far!

The other alternative to garner AUMs (assets under management) -- announce big, sometimes really big, dividends. Then, of course, at the cost of the existing unit holders of the funds, advertise this dividend announcement aggressively. The result -- the AMC mobilises a lot of money (mostly in its equity funds) from two types of investors -- the gullible ones who think that this is a return on their investment when in fact they are just getting their own money back.

In either case, the quality of monies mobilised by the AMC is not what it ideally should aspire for. Moreover, sooner or later the gullible investor will learn of these 'tricks of the trade.'

But, thanks again to SEBI, this practice has come to a grinding halt with immediate effect! On the announcement of this new initiative by SEBI, we were left wondering about the recruitment that is about to take place in the marketing departments of the AMCs!

But in light of all these steps taken by the regulator, why are we still saying that the industry is going from bad to worse?

The reasons are not far to seek.

The analyst who is writing this note very recently received an email from an AMC announcing the launch of a new mutual fund scheme. Here is a line from the email -- 'We are pleased to announce the launch of Gullible Investor Equity Fund (name changed). The fund will invest in company IPO's. The fund will sell the holdings on listing.'

The fund is, of course, aimed at capitalising on the investor interest in the initial public offerings (IPOs). So what's wrong with that, you say? Well, here is our view:

One, equities/equity funds as an asset carry high risk. They are suitable only for holding periods in excess of three years in our view. In case of an IPO, the time between allotment and listing is about 2-3 months.

A fund which has taken a call to sell on listing is surely either looking at investing in undervalued IPOs (from a good company in a bull market?) or expecting the markets as a whole to become relatively more expensive in this time period thus benefiting the newly listed company. The first scenario is unlikely; the second, speculative.

Two, even if there were good companies coming to the market with very attractively priced offerings, it is unlikely that the fund will get its desired allocation (remember, the mutual fund industry is very large; and existing diversified funds anyways participate selectively in IPOs).

In such a scenario would the scheme hold cash (could impact tax status) or invest in other stocks (like any other fund). What if the IPOs dry out like in 2001 or 2002?

Three, in a scenario where the IPOs are from a particular sector (like IPOs from the Telecom-Media-Technology in 2000) the mutual fund scheme may find itself with a very concentrated portfolio, thus increasing its risk profile still further.

Four, our experience suggests this fund will be marketed heavily resulting in thousands of retail investors coming on as unit holders. These investors have short memories with respect to IPO funds (remember the mid 1990s or the 1999 - 2000 era). There will be little education about the risk such a fund carries; in fact, in all probability this fund would not suit the risk profile of most of its unitholders. More mis-selling?

And this brings us to the most important point -- investor education (as distinct from support to mutual fund distributors). The mutual fund industry in our view has done little to educate the retail investor. The recent flood of money is the result of attractive returns, which are unsustainable mind you, and very aggressive incentive structures offered by some AMCs to select distributors. It is hardly a result of investor education initiatives by the industry.

The investment-conducive environment should serve as an incentive for AMCs to strengthen the foundations of the industry by taking up 'genuine' investor education initiatives. If this opportunity is missed (like so many times in the past 14 years) the damage this time may be much longer lasting.

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