Cleaning Up The Mutual Fund Industry (21 July 2003)
Over a decade ago, the government encouraged Indian retail investors to invest through mutual funds, telling them that professional fund managers will keep their money safer. Instead, the Unit Trust of India (UTI) debacle, frequent miscalculations on returns, premature closure of schemes and other problems have kept the retail investors away.
Instead of becoming a common man’s vehicle, the Securities and Exchange Board of India has recently discovered that mutual funds too have turned into a vehicle for High Networth Individuals (HNIs) and companies. Highly paid fund managers in fact, seem to help companies take advantage of tax shelters that were provided by the government to attract retail investors into the mutual fund fold.
Last Friday, SEBI summoned the CEOs of all mutual funds to take stock of the situation. The regulator was worried by the stunning information provided by Value Research — an independent mutual fund research company (reported by this paper on July 19) — that as many has 27 mutual fund schemes had just one investor holding anywhere between 23 to 90 per cent of the corpus. Of these, eight funds have single investors holding 80 to 100 per cent of the corpus. What is worse, all top mutual funds including, ING, Prudential ICICI, JM Mutual Fund, Cholamandalam and Tata TD Waterhouse had such single investor schemes.
In effect, this investor—probably a company—had the benefit of a portfolio management scheme masquerading as a mutual fund, with all the tax benefits of the latter. More importantly, unlike Initial Public Offerings (IPOs) where the listing rules mandate a minimum number of investors, SEBI has no equivalent rules for mutual funds. The revelations only expose more of the regulatory lethargy that had gripped SEBI over the last eight years. But mutual fund CEOs think that this may not be the only example of mutual funds using their ingenuity and expertise to cater to the corporate sector and HNIs.
What mutual fund chiefs had expected but SEBI failed to discuss, says my source, is the proliferation of fixed maturity schemes (again floated by all funds) tailored for the corporate sector to get fund management expertise and tax benefits. Fixed maturity plans are those were the fund invests in financial instruments whose maturity coincides with a specific time-period indicated in advance by the fund. Essentially, says our source, these are short term inter-corporate deposits, routed as mutual fund investments and extinguished before the close of the financial year. On redemption, investors who have held the scheme for at least a year, get the benefit of indexation for capital gains, which is not available to fixed deposits and bonds. Hence, even though the actual return may not be better than that from term deposits of private banks, they have the advantage of tax benefits and become a treasury management tool.
Many of these schemes also invest in a single security that matures at a particular date and most single investor schemes are likely to be in this category. Such schemes are a negation of the very concept of mutual funds, where expert investment managers are supposed to hedge risk by investing in a basket of securities.
Between schemes that have just one investor and inter-corporate deposits in the guise of mutual funds walking away with tax advantages, it is clear that SEBI’s rules need a serious relook.
Sources say that SEBI may soon initiate a complete rejig of mutual fund regulations and also examine why mutual funds are becoming a tool for companies and HNIs rather than for retail investors. It may also try to figure out why retail investors are disinterested in mutual funds and examine persistent charges that many fund managers tend to front run their investment decisions despite compliance rules.
In this context, the study by LC Gupta, a former director of SEBI, has some insights (Why Ordinary Investors Remain Disenchanted; by LC Gupta, Naveen Jain and Utal Choudhury, June 2003). It reveals that although investors are disinterested in equity investment, they are even less enthusiastic about mutual funds being able to provide a superior alternative to their own investment judgement. Ten years after the end of Unit Trust of India’s monopoly, an “overwhelming number of investors prefer direct shareholding instead of mutual funds”.
Clearly, if the tax breaks doled out to mutual fund investment every year are to be justified, then the funds have to make an all out effort to make themselves attractive to retail investors.
In fact, the failure to attract individual investment could affect the very survival of several funds. Considerable consolidation has already occurred, with several funds choosing to sell out and exit the business. For instance, Templeton bought Pioneer ITI, Birla Sunlife provided an exit to Apple Mutual Fund, Sun F&C acquired Jardine Fleming Mutual fund and it is in turn trying to sell out to IDBI Principal. Similarly, Newton Investment merged with Sundaram Finance to form Sundaram Newton and more recently, Zurich Mutual Fund sold out to HDFC Mutual Fund.
While UTI has been split, its consolidation process is far from over. Ideally, UTI-I would slowly be wound up, while UTI-II has to find a strategic partner and also eliminate any conflict of interest with its four sponsors — Life Insurance Corporation, Bank of Baroda, State Bank of India and Punjab National Bank. It can do this by gradually providing an exit route to the sponsors, but only after the government lets go of what is still India’s largest mutual fund.
The good news is that UTI-II is doing well and is getting ambitious about growth. It is logical for UTI to want to grow, especially if investors are willing to entrust their money to it once again. But that would be most dangerous, while government-owned institutions continue to hold substantial stakes in UTI-II and politicians retain ways of meddling. So far, government has shown no inclination to distance itself from Unit Trust and even has its own nominees as advisors to the Trust.
Any attempt by SEBI to clean up the mutual fund industry will have to take all these factors into account and focus on building enough trust among retail investors in order to make the business grow. -- Sucheta Dalal