Srinivas Chittaluru is not the kind of man who reads four pink papers with his morning coffee and then devours research reports with breakfast. With around Rs 10 lakh in the market, you’d think this 41-year-old software engineer would be far more tense than he is about the state of the markets. But Chittaluru, who has been investing since 1995, has seen the market rise and fall and knows it will ultimately stabilise. More importantly, he has not put his money in stocks and has chosen to invest only through mutual funds. “Unlike stocks, mutual fund investment is less risky and offers scope of diversification,” he says. And he’s tested this for himself. He moved his equity investments to debt funds this January, and has also branched out into gold and new thematic funds, which he hopes will pay out over the next three years or so. Chittaluru could be the poster-boy for the Indian mutual fund industry—savvy and unfazed by temporary swings.
But why are there so few of them in the country? Retail participation in mutual funds in India is pathetically low; less than 3% of household savings go to MFs, compared with over 15% in the developed countries. So where do people invest if not in funds? They swing wildly between two extremes—safe and poorly paying bank accounts on the one hand, and direct equities on the other. The reason why funds are not on the preferred list of retail investors is largely due to the way in which fund houses in India operate.
|
| "Mutual fund investing disciplines you to stay invested and book profits when they are big. With closed-ended and tax-saving equity schemes, the lock-in period forces you to ignore the noise that the market makes." |
An industry insider puts it well when he says that the fund houses are becoming asset gatherers instead of being asset managers. The numbers back him; the collective assets under management of the industry doubled between January 2006 and August 2007 (see ‘AUM Erosion’). Fund houses seem to be in some sort of a race for the largest AUM—invariably, the more the assets of a fund, the more likely it is to attract investors. The easiest way to increase assets is by chasing corporate money (see ‘Preferential Treatment’). Retail investors were tolerated and occasionally told that the funds were for them, but never really wooed actively.
Fixed maturity plans or FMPs, for instance, were structured to allow corporate investors and HNIs to park their excess cash for short tenures at attractive indicative yields. They became so popular that some fund houses took the FMP route to shore up their AUMs. Between January and October this year, fund houses launched 1,174 FMPs, compared with 755 last year. As a product, the FMP worked as it was a good tax arbitrage mechanism and the investors were safe as the money was invested in equal tenured debt papers (see ‘Where Do Debt Funds Invest’). So far, so good. Why did things go so wrong?
PREFERENTIAL TREATMENT Mutual funds might be the small investor’s best friend, but fund houses are more focused on corporates, institutions, banks, trusts and HNIs, since 80% of the AUM comes from these big players. Here’s how the institutional bias shows: | |||
| ADVANTAGE FMPs Due to their fixed maturity horizon, FMPs help save tax, from 33.66% to the dividend distribution tax of 14.03% in case of individuals and HUFs. | |||
| BANK FD | FMP (INDIVIDUAL) | FMP (CORPORATE) | |
| Pre-tax yield | 8 | 8 | 8 |
| Tax | 33.66 | - | - |
| Dividend distribution tax | - | 14.03 | 22.44 |
| Post-tax net yield | 5.31 | 6.88 | 6.20 |
| All figures are in percentages | |||
THE ROOT OF THE PROBLEM
Imagine a mutual fund with assets of Rs 1,000 (worth par), 100 units of Rs 10 each, and net asset value (NAV) of Rs 10. Now assume that, for whatever reasons, the quality of the assets deteriorates, and is now worth only Rs 880. If the instruments are liquid, the fund will mark its holdings down to market value and the NAV will drop to Rs 8.80. However, if (as seems to be the case today) the instruments are illiquid and not well-traded, the fund pretends that all is well and that there’s no fall in the value of its assets. On paper, therefore, the NAV remains at Rs 10. The problem occurs when there is a redemption request for, say, 20 units. Because the NAV remains Rs 10 when the assets are worth Rs 8.80, the fund has to borrow to pay Rs 200, and it has only 80 units left to absorb the loss on assets. The true NAV falls to Rs 8.50. What this means is that the other investors who have stayed in the fund lose 30 paise so that one investor can exit without a loss.
_3_thumb.jpg) The assets managed by debt and equity funds were almost the same in March 2006, but because of FMPs, the debt component has grown rapidly. The ‘others’ category includes MIP, gold and hybrid fund categories. The fall across categories has been steep since September 2008. |
The scary part is that this is not just a hypothetical example; it’s actually happening. Ask Dr Ranjit Kumar, who is fighting shy of mutual funds now. His investment of Rs 24,000 is worth Rs 17,000 today. In the real world, investors found out that funds’ assets were actually poor. The trigger was the real estate crisis and the consequent fall in demand for real estate paper. Corporate clients of FMPs feared that one big player, Unitech, might default. Overnight, portfolios with real estate assets were seen as risky, and a wave of redemptions began. This is where things begin to seem almost surreal. Corporate clients suffered a loss to get out of FMPs, and most of them put the redemption proceeds into the banks. These banks had issued certificates of deposit, which is what most FMPs held. Essentially, the corporate investor made a heavy loss only to invest in the same instrument all over again.
WHITHER RETAIL INVESTORS?
Unfortunately, retail investors, who form a minuscule portion of MF investors, decided to follow the example set by their larger peers. Most of them decided to redeem when the panic was at its peak and everybody was scrambling to exit. In our hypothetical case, the fund would have been forced to sell its assets at 80% of its value, instead of 88%, and the NAV would have fallen to Rs 8. If, like Chittaluru, more small investors decide to ride out the storm, they might see the value of the fund’s remaining assets go up to 88%, which is a gain of 30 paise.
The huge problem now is that the assets might not rise to the fundamental value because the quality of the investments is suspect. Mutual funds are refusing to divulge the quality of their investments, much of which has been steadily deteriorating. Corporate investors must have figured this out and so exited early, leaving the retail investors holding the bag. Unfortunately, this has happened too many times in the 20-year history of mutual funds in India (other than UTI, which has been around since 1964). It was only in January this year that the regulator stepped in to give the retail investors some respite. But it might have been too little, too late.
ENTRY LOAD
The fund houses were directed to treat retail and institutional investors on par, and not charge an entry load. However, there are strings attached; funds will continue to charge an entry load if retail investors enter through an intermediary. Which immediately puts all non-metro-based small investors at a disadvantage. There are also cases of fund houses charging an entry load from day 2, but so far, no regulatory action seems to have been taken.
GUARANTEED RETURNS
The fund houses are still spending more time and energy wooing corporate clients. Even as you read this, several mutual fund houses have cut off-market deals with corporate and financial institutions to fight the cash crunch. With redemption pressures amid a liquidity squeeze, some fund houses have given ‘guaranteed’ returns to bigticket investors who were willing to bail them out by parking money in specified MF schemes for a few weeks. Under the arrangement, even if the net asset value (NAV) of the scheme dips, these investors will be allowed to exit at a higher, pre-agreed NAV.
How can a fund offer guaranteed returns, even unofficially? The asset management company pays the extra return, or it can be shown as marketing expenses. Some funds even charge this as expense in an existing scheme, where expenses can be amortised over the life of the scheme. According to an industry veteran, it’s virtually impossible for investors and even auditors to get wind of such transactions.
In other, developed markets, mutual funds are seen as ideal vehicles for retail investors. There, investing directly in the stock market is considered a risky game that only the big players can afford to play. Here, however, it appears that all instruments are skewed in favour of the large corporate investor. Is it any wonder that small investors have lost confidence in fund houses and are ready to exit at the least sign of trouble?
WHERE DO DEBT FUNDS INVEST? If you invest in a debt fund, it will help to know where your money goes |
LESS THAN ONE YEAR COMMERCIAL PAPERS: These are issued by companies and the risk is low due to a lower tenure. Short-term debt funds invest in them. CERTIFICATES OF DEPOSIT: It is the same as a CP, except that these are issued by banks. Usually, short-term funds or FMPs invest in these papers. COLLATERALISED BORROWING AND LENDING OBLIGATION (CBLO): This is an overnight window offered by the Clearing Corporation of India. Liquid funds invest here for a day or two. TREASURY BILLS (T-BILLS): They are issued by the Government of India and have tenures of 90, 182 and 364 days. They are extremely safe. Shortterm debt funds invest in them. |
ONE YEAR AND ABOVE CORPORATE BONDS: These are bonds issued by PSUs and are rated by credit rating agencies. Medium-term and long-term debt funds usually invest in them. DEBENTURES: Issued by Indian companies, these bonds are also rated. Medium- and long-term bond funds invest in them according to their investment mandates. SECURITISED PAPER (PASS THROUGH CERTIFICATES): These are papers issued by banks securitising a loan that they have offered to a single corporate. Long- and medium-term bond funds invest in these. GOVERNMENT BONDS (GILTS): These are issued by the Government of India and carry sovereign guarantee. They are considered safe. Special gilt funds invest in government bonds. |
— With Tanvi Varma and Shruti Kohli
_1.jpg)
_2_thumb.jpg)