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The truth behind mutual fund industry

Sundaresha Subramanian / New Delhi 13 Jul 12 | 12:43 AM

Is the mutual fund industry gasping for air? It certainly seems to think so, since it has been lobbying hard to get some kind of relief from the government in the form of an increased expense ratio.

The question is, does it need to? Or, is this just smoke and mirrors perpetrated by an opportunistic industry?

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Expense ratio is the amount, expressed in percentage of total investments, the fundhouse charges its investors to meet operating expenses, asset management fees, administration expenses and other asset-based costs. At present, this is capped by the regulators at 2.25 per cent for equity funds, and is proposed to be increased by 0.25 per cent. In other words, funds are going to be 11 per cent more expensive.

The logic advanced to the government is that the increase in expense ratio will help fund houses pay more to distributors, who are struggling after the ban on entry loads.

Distributors sitting pretty
But, do the distributors need to be paid more? According to the data released by Association of Mutual Funds of India (Amfi) earlier this week, some 269 top distributors, including banks and corporate distributors, who account for the lion’s share of the industry’s assets, earned a healthy amount — a total Rs 1,860 crore in 2011-12, up five per cent from Rs 1,770 crore earned in the previous year. In fact, the top fund houses have seen a rise of five to 22 per cent in their profits for the year 2011-12, despite paying five per cent more to their major distributors.

One explanation given by fund houses for an expense ratio increase is that it will allow them to expand the retail investor base in the country and usher in new investors; but this, too, is hard to believe. Arjun Parthasarathy, editor, Investorsareidiots.com, a website focusing on investor education, explains that even at the peak of the bull run, the retail base was never great. “The funds get the bulk of their assets from corporate and HNIs (high net-worth investors). To grow fast, funds want to push more products to this existing wholesale base. That is why they want a higher expense ratio," he adds. Besides, growing a retail base is time-consuming. “Retail will never give mass and it won’t grow as fast," says Parthasarathy, who headed the debt fund management team with IDFC a few years ago.

THE BIG GET BIGGER
The proposed measure of increasing the expense ratio is likely to benefit the biggies disproportionately, as they hold the lion's share of assets, earn hefty fees and spend little relatively
Marketing /staff expenses of profitable fund houses (Rs crore)
AMC Asset mgmt
fee
Staff 
costs
mktg
expenses
Mktg/AMC
fee (%)
Staff costs/
AMC fee (%)
Reliance  597.19 126.60 30.09 5.04 21.20
HDFC 562.52 85.88 10.31 1.83 15.27
UTI 420.40 148.47 13.00 3.09 35.32
Franklin 354.53 106.67 9.46 2.67 30.09
Birla 313.87 100.68 15.28 4.87 32.08
ICICI 281.21 84.05 4.80 1.71 29.89
Fee/expense structure of loss-making funds (Rs crore)
AMC Asset mgmt
fee
Staff
costs
Mktg
expenses
Mktg/AMC
fee (%)
staff costs/
AMC fee (%)
Fidelity 70.75 68.12 17.05 24.10 96.29
LIC 86.86 16.77 6.81 7.84 19.31
Religare  33.50 30.86 43.85 130.89 92.12
Axis 22.76 24.88 0.39 1.72 109.29
L&T 6.60 18.67 13.76 208.38 282.89
Pramerica 1.30 19.72 2.64 203.40 1,521.17
Figures for year ended March 2011.                Source: BS analysis of Value research data 

When confronted with the robust profit numbers of fund houses and their distributors, an Amfi official said the struggle was in the space of small distributors, but didn’t quantify them or their losses.

According to a McKinsey survey, soon after the regulatory changes made in 2009, less than half of the industry’s retail assets came from one-man distributors called independent financial advisors (IFAs). This means while the large distributors, such as banks, cornered almost all corporate and HNI business, they also had around half the retail business. The IFAs have 10-12 per cent of the industry’s Rs 6.6-trillion assets under management.

Have these small IFAs stopped selling? N K Prasad, president & CEO, Computer Age Management Services (CAMS), a registrar which manages the accounts of mutual fund investors, says “new accounts are being opened but the number of such new accounts have declined. Then, there is a marginal fall in the number of systematic investment plans (SIPs). Third, there have been net outflows from equity funds."

Investor woes
One reason for fewer new accounts is the lack of new fund offers (NFOs). Between 2003 and 2008, NFOs ruled the mutual fund market. Hundreds of those hit the market and collected thousands of crores. According to the McKinsey study, industry assets grew at a whopping 45 per cent compounded annually during this period. The bull run in the equity markets provided the perfect backdrop. Distributors often tricked investors into exiting their existing investments and enter NFOs on the pretext that these were cheaper. This led to a huge number of accounts being opened. However, Sebi has since tightened the rules for clearing new schemes, and made it tough for funds to launch those not genuinely different from the existing ones.

Prasad says lack of NFOs could be one reason, but not the only one. “It could be because of the markets, or because of the decline in the NFOs. It is difficult to pinpoint," he says. Given the facts, how would new retail investors, or existing ones, take to the hike in the expense ratio? Problem is, according to Parthasarathy, the sentiment of the retail investor is badly hurt. “Many are sitting on losses. It is difficult to win back the confidence."

There’s a reason for this. In June, Sebi Chairman UK Sinha pointed out that nearly half the industry had a significant number of schemes underperforming their benchmark indices. Beating the returns provided by the index against which a scheme is benchmarked is the main objective of a fund manager. According to Sinha, “at least nine fund houses had more than 50 per cent schemes consistently lagging their benchmark over a three-year period." Another nine had up to 50 per cent of schemes in the laggards’ list.

This essentially means investors were paying the fund houses a fee of Rs 2.25 to grow their Rs 100 to, say, Rs 120. Thus, the the net gain via an ‘expert’ was Rs 17.75. On the other hand, if the investor had blindly invested in the benchmark, his return would have been Rs 21, or higher. Also, he would be saving the Rs 2.25 paid to the fund.

Instead of confronting this widespread underperformance — which affects the confidence of the retail investors and is a catalyst for the closure of accounts and outflow of money — the industry wants the government to add insult to injury by upping that Rs 2.25 fee to Rs 2.50 on every Rs 100.

Experts agree the higher expense ratio will hurt the retail investor most. Does anyone care?

Experts say one thing that can bring investor confidence back is a sustained bull run. But with the economy not inspiring anyone, funds would do better to concentrate on investing more on quality talent and strengthening their investment management departments. “Globally, the mix of investment infrastructure cost and marketing cost is 70:30. Here, it is the reverse,"says Parthasarathy.

Entry barriers are low. A star fund manager in Mumbai is rumoured to have bought an apartment worth Rs 50 crore in central Mumbai. It takes just a fifth of that to set up a fund house, according to Sebi rules. “The authorities should make rules to ensure adequate investment in investment infrastructure. While it is easy to set up a fund house, running it well is an expensive affair. This is where funds are faltering," says a fund manager.

The fund industry had created a model, wherein it set up shop with minimum capital and acquired assets by paying the distributors from investors' money. With the ban on entry load, that model is no longer sustainable. Instead of adjusting to the new environment, the industry seems to be daydreaming about going back to good old days.

In a recent interview to Business Standard, Sebi chief Sinha said the industry cannot sustain 44 players. Making rules to strengthen the capital base of these and ensuring a lion’s share goes to managing schemes, rather than mindlessly selling these, could be one way of reducing that number, and focusing on what’s really at stake — the retail investor.

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