Mutual Fun- No longer fun

(This appears in the recent issue of Moneylife Magazine)

Everyone is hammer and tongs at the mutual fund industry. Going by the noise, one would think that the Asset Management Companies make a pile of money. A reading of the annual accounts of the AMC’s will tell you otherwise.
SEBI is akin to the religious zealot who is so focused on the rituals that the object of worship is forgotten. The regulator is on a zealous overdrive to bring ‘transparency’ in to the industry. What the regulator does not realise is that the mutual fund economics in India are pathetic and designed such that the AMC will end up chasing the bulk investor. The small investor has become the ‘holy cow’ for the regulator.
As per SEBI rules, a Fund (or the scheme) is permitted to charge a maximum of 2.50 percent of the Assets Under Management for any scheme. There is a sliding scale where the 2.50 percent drops down to 2 percent depending on the size. This is for equity assets. For debt assets, the scale is lower by one half of a percent.
Let us, keep the number at 2.50 percent for the sake of convenience. 2.50 percent is the maximum permitted. This is to cover the following expenses:
i) Selling commission to the distributor;
ii) Selling expenses;
iii) Expenses on R&T :
iv) Fees to Trustees;
v) Audit fees;
vi) Communication to investors;
vii) Fees to SEBI; and
viii) A management fee to the AMC.
The management fee is typically kept in a range between 0.50 to 1.00 percent of the AUM. From this management fee, the AMC has to meet its entire costs of managing the scheme (salaries, investment management costs, office costs, rents, branch expenses, communication costs, legal expenses etc). There is also a huge burden of ‘compliance’ costs that an AMC bears. All employees are on the payroll of the AMC. I leave it to you to do the numbers.
Do not fall in to the trap of calculating full fees on Liquid Funds and FMP assets. Here the total costs will be limited by competition to between 0.10 percent to 0.50 percent and are more like show piece numbers to display size.
In this context, let me take the case of this strange animal called the ‘small investor’. Let us say he puts in Rs.10,000/- in an equity fund. Out of this, the fund will deduct Rs.250 over a 12 month period as the maximum fees. Of this 250, anything from Rs.100 to Rs.150 will go to the distributor or seller who solicited the amount. So, there is a balance of 100 to 150 to cover expenses and pay management fee! For a 10,000 rupee investor, the mailing costs, transaction processing costs itself would take away anything up to Rs.50/-. These kinds of costs are the same irrespective of the size. Thus, an AMC has no business to actively chase kinds of investors. If they are doing this, I think it is in the hope that at some point there will be so many that they can break even. My feel is that on each incremental ‘small’ investor, an AMC can only lose money, unless he is a ‘direct’ acquisition with zero selling costs, opts for full electronic delivery of reports etc.
In the past, the AMC would charge an entry load of 2% (Rs.200 on the 10,000/-) and pass it to the distributor. Now SEBI has closed that. In addition, SEBI has prohibited AMC’s from paying upfront commissions. This is in fact a ‘restrictive’ trade practice. If the AMC is sticking to the legal limit of expenses, why should SEBI worry? AMC’s will have to fund the upfront from the AMC and when they get the management fees, they will hopefully recoup this. That is what will happen.
Is there a way out of this imbroglio? I think SEBI should stick to the following:
i) No entry loads on ‘direct’ investments by investors;
ii) Entry loads of up to 2 percent on those who come thru an intermediary.
This is the immediate need if the mutual fund industry has to achieve any kind of penetration. LIC was able to get in to small villages and towns only because the agents got their 40 percent commissions on the first year premium and a minimum of 5 percent of subsequent premiums. Mutual funds and Insurance products are things that have to be ‘SOLD” and are not needs for anyone. So, if something has to be sold, someone has to be paid. That is economics.