The great mutual fund crisis

Fund houses are facing redemption pressure. We look at what triggered the current turmoil and why mutual funds are biased against retail investors.

Narayan Krishnamurthy | Print Edition: December 11, 2008

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.

Srinivas Chittaluru, 41
Has invested in mutual funds since: 1995
Has Rs 10 lakh invested in mutual funds now

"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?


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:

»Till 1 January 2008, only retail investors had to pay an entry load; corporates did not need to do this. Now, retail investors can eliminate the entry load only if they go directly to a fund house and do not use an intermediary.

Institutions earn higher returns, sometimes even guaranteed returns.

Fixed maturity plans or FMPs were primarily designed for corporates to make use of a systemic lacuna in tax arbitrage.

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.
Pre-tax yield888
Dividend distribution tax-14.0322.44
Post-tax net yield5.31
All figures are in percentages


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