The asset chase

But industry observers agree that the new launches are driven out of business compulsions. The mutual fund business is really a volume game. The more money you manage, the higher is the return on your investment. But getting more money isn't easy. On the one hand, competition has been hotting up with several large players, especially banks, getting into the fund business. On the other hand, investors are far from accepting mutual funds as their favourite investment.

Not just that. Till 2003, fund houses were in a much better situation with debt funds raking in enough moolah driven by powerful returns and tax-efficiency. But both these drivers have vanished. Blame it on the rising interest rates - debt funds have turned in dismal performance in the past couple of years. And thanks to the finance minister, the tax arbitrage is also waning. Which means fund companies are more desperate than ever before to up their assets under management. "Every fund company is facing market pressures today," says Krishnamurthy Vijayan, CEO, JM Mutual Fund.

This is where buoyant stock markets come in handy. Taking advantage of the exuberant mood in the markets, fund companies have been increasing their sales pitch. "If investors are willing to buy only funds available at par, fund companies will sell them what they want," says Sameer Kamdar, national head, Mata Securities, " Funds are also under pressure because they have to keep expanding their asset base, apart from expanding their product profile," he adds.

Most fund companies, small and large, have ensured they grab what is due to them. As the Sensex gained momentum, the pace of new launches has only accelerated. For instance, in March 2005 alone, when the Sensex was hovering around 6500, eight new growth schemes were launched. These collectively mopped up Rs 7,016 crore. Within two months - in May 2005 - another seven growth schemes were launched which together collected Rs 4,136 crore (See table).

At the forefront has been Reliance Mutual which launched half a dozen equity funds between June 2004 and June 2005, followed by Prudential ICICI and Tata Mutual which launched four funds each during the period. Similarly, Cholamandalam, Principal, Kotak and SBI have also actively launched new funds.

Ved Prakash Chaturvedi, MD , Tata Mutual Fund, which has been in the thick of launching new funds in the past year or so, strongly defends the logic of launching funds. "Short-term pressures were never a concern for us. We identified the gaps in our portfolio and came out with well-thought out products," he says. However, a few funds have consciously refrained from joining the melee. That has meant losing their rank in the AUM sweep-stakes. Among the big names, DSP Merrill Lynch has not launched a single fund in the past one year. Understandably, its assets under management have remained almost stagnant at Rs 6,000-odd crore.

Clearly, much of the contribution to the new funds has come from ignorant investors who do not understand that investing in new offerings is meaningless. Or that distributors make more money by selling new funds - both of which are bad.

Rogue distributors

Several funds such as UTI Mutual Fund and Franklin Templeton have been making high dividend pay-outs. Apart from making the fund investors feel rewarded (dividends are always a feel-good), it means periodic booking of profits, and also reduces the NAV. Yet this has not done enough to reduce NAVs substantially to get retail investors to see 'value' in these funds once again "because that is only part of the problem," says an industry observer.

The main problem is that there is no one to tell these investors that the fixation with par value does not quite help. But the fact of the matter is that investors make decisions based on what distributors say, and distributors have a vested interest in whatever they say or do. Fund companies themselves are doing little to ensure that the situation is corrected.

Low trail means distributors do not have much incentives to ensure that investors stay invested in their existing schemes

All new funds launched in the past few months offered high upfront commissions with the exception of Fidelity. The largest mutual fund in the US, which entered the Indian market this year, decided to play by its own rules. The fund offered an upfront commission of 2.25 per cent and trail commissions of 0.6 per cent for the first three years and 0.5 per cent from the fourth year onwards. While higher trail is an incentive for distributors to ensure that the money stays with the fund, Fidelity also supports distributors in more meaningful ways. "They are willing to foot the bill for any investor conferences or investor awareness shows organised by us," says a distributor.

Point taken. But some fundmen also argue that not all mutual fund companies enjoy the same kind of pricing power that Fidelity does. As the world's largest mutual fund Fidelity has immense clout. It has relationships with several leading banks globally, and none would like to displease the global mutual fund behemoth.

Churn and burn

And these churns were effected by major institutional distributors, including leading banks. Top churns include IDBI Capital Market Services, ABN Amro Bank NV, Standard Chartered Bank, SBI Capital Markets and NJ India Invest. Nearly half of the top 20 distributors churned their allocations over 50 per cent within a year .

Evidently, even the evolution of institutional framework - read banks - to sell mutual funds isn't doing any good. Nearly, 60-70 per cent of retail collections come from banks. But the jury is still out on whether this has helped in improving investor awareness and attracting new breed of retail investors. More importantly, whether it's the dumb money that chases new schemes or the sizzling hot money that gets a cut from the distributor, it has its perils. "If investors are buying a new fund because it is available at par, they may be in for a major disappointment which could once again hurt investor confidence in mutual funds," says Bluechip managing director, S Rajagopalan. Bluechip is one of the few distribution firms which does real retail business.

Even worse is hot money which moves out of new funds the moment it opens the sales window. Here is how. Usually, fund companies amortise issue expenses over five years and this charge is deducted from the asset value daily. In other words, new investors in an ongoing fund also bear issue expenses while an investor who invested in the fund during the initial public offer could cash out at the first available opportunity, without paying his share of issue expenses.

Logically, issue expense is the cost related to a fund launch. Why should an investor who did not participate in an initial offer have to bear the burden of issue expenses? Obviously, this works in favour of short-term investors as there is no penalty for stepping out early. Several institutional distributors are notorious for broking deals where short-term investors put in money in the initial public offer and pull out quickly. While the fund company can pat itself for great IPO collections, distributors make hefty upfront commissions and the oversmart investor pockets a part of the distributor commission and exits the fund without paying a penalty. The casualty here are the remaining investors who ultimately bear a high issue expense.

Is there a solution?

It is not as though there is no remedy. All this while fund companies have been taking shelter under the pretext that distributors are their link to investors, and that they could not be held responsible for the misgivings of distributors. If mis-selling is rampant, it is not as though fund companies can't do their bit to stop it. Several fund companies have been clamouring to make pass-backs legitimate as in several other financial instruments. Pass-backs happen not because of the distributors' love for their clients but because there is enough to share, and there are enough companies who are willing to pay the price.

It's not rocket science to figure out the corrective measures that need to be taken. To begin with, the incentive structure for new funds should be on a par with existing funds. Upfront commissions should be slashed and evened out as trail commissions so that distributors are inclined to ensure that the money stays with a fund for a longer time. However, this is one point that may find few takers. According to Rustagi, upfront commissions for distributors are not such a bad thing. "There is an effort involved in selling the concept of equities and mutual funds. In it only natural that distributors be rewarded for their efforts," he says. Kamdar, however, agrees that upfront commissions should be evened out.

Also, issue expenses should be front-ended to ensure that it acts as a deterrent for investors to pull out money. If not, there should be an exit load which should be ploughed back into the fund and not pocketed by the fund firm or the distributor.

Besides, there should be a mechanism of tracking rogue distributors and even investors who have a tendency to move in and out frequently. A distributor rating could be developed and shared by all the fund companies, the industry association and the regulator. But all this can't be implemented without the collective effort of all the fund companies. Is anyone listening?