Prima facie, the intention to cast mutual funds as a long-term investment certainly appears most noble. But scratch the surface a little and these intentions assume a 'not-so-noble' character. To begin with, pitching close-ended funds as a long-term investment product that enables the fund manager to take long-term investment calls appeals to reason. However, it instinctively raises the query, why close-ended funds are being launched only in the recent past. Weren't they always a long-term investment proposition?
AMCs have smug answers for this; they are at pains to explain how the investor wasn't prepared for close-ended funds earlier, but maturity has set in rather belatedly and investors are ready for close-ended funds now.
To this rational response, we would like to add another small reason as to why close-ended funds have shot into the limelight over the recent past. It was around this time last year when Securities and Exchange Board of India came down heavily on the high commissions (at times as high as 6 per cent) lavished by fund houses on mutual fund distributors. This lead to NFOs being marketed aggressively and sold unscrupulously by distributors to pocket the attractive commissions.
To curtail this malpractice, Sebi issued a decree - commissions on all open-ended NFOs could only be restricted to the entry load. Since the entry load on most equity funds is 2.25 per cent, this implied that open-ended NFOs could not offer commissions exceeding 2.25 per cent.
It was obvious that mutual fund distributors accustomed to 6 per cent commissions weren't going to sell open-ended NFOs at a pittance of 2.25 per cent. On the other hand AMCs were bent on taking the NFO route to beef up assets. This was a classic deadlock that could be broken only in one way and both AMCs and distributors willingly embraced that option. Welcome close-ended equity NFOs, the long-term investment option that allows the fund manager to take long-term investment calls!
It is obvious how close-ended NFOs came on the stage; SEBI guidelines kept the door ajar for AMCs to give higher commissions to close-ended NFOs. And AMCs made the most of this 'flexibility'. So while commissions on open-ended NFOs are invariably in the 2.25 per cent region, commissions on close-ended NFOs can go as high as 6 per cent. This should provide ample proof on how close-ended funds have suddenly emerged as the long-term investment option for the very 'mature' Indian mutual fund investor.
But this note is not about close-ended funds. That was last year's fad on promoting long-term investing. Now the in-thing is slapping an exit load on investors who lack discipline to remain invested for a pre-determined time frame. This is another measure to encourage long-term investing because short-term investors hurt the interests of long-term investors who stay behind.
Let us understand how investors who flit in and out of mutual funds aimlessly hurt existing investors with a focused, long-term investment objective. When an investor exits from a mutual fund, the fund manager has to arrange for his redemption proceeds.
This is often done through the cash allocation (most equity funds have at least 5 per cent in cash) that is usually kept handy for redemptions. If the fund manager cannot meet the redemption request through the cash allocation, he will have to sell stocks to generate cash. It is possible that the redemption request forces his hand into selling a stock that he would rather not have sold.
So if a good stock is sold because some investor got bored after being invested for 3 weeks, the long-term investor who has been patiently invested loses out on a great investment because the fund manager had to sell one of his best
That's not the only way short-term investors harm the interests of long-term investors. Every time an investor invests and redeems his holdings, expenses are incurred like registrar fees for instance. These expenses are deducted from the net asset value.
As more and more investors invest and redeem, especially those with a short-term investment time frame, these expenses can add up to quite a bit eroding the fund's NAV. The short-term investor won't mind the NAV erosion so much because after all it is his redemption that is causing it. It is the long-term investor who feels short-changed because investors around him are redeeming away and he (long-term investor) has to deal with a fall in the NAV of his investments, for no fault of his.
To tackle this problem and 'comfort' the long-term investor (and thereby promoting long-term investing), AMCs came up with the idea of slapping an exit load on short-term investors (the definition of short-term differs, but usually ranges from 6 months to upto 2 years for most AMCs). This way, the interests of the long-term investor are safeguarded because the outgoing short-term investor is paying an exit load and in this way 'compensates' the long-term investor.
So far it all sounds pretty investor-friendly, so why are we calling it a con job? It's because the money collected by way of exit loads is amassed on the pretext of safeguarding the investor's interests, but is employed by the fund to provide for, among other expenses, the mutual fund distributor's commission.
You read that right; the mutual fund distributor among other parties is a major beneficiary of the monies collected by way of exit load. The investor's interest is merely the reason (or a façade as they say) for collecting the exit load; eventually it is the marketing and sales promotion activities of the AMC that reap the benefits of an exit load.
So ideally how should the monies collected by way of exit load be employed? In our view, if the exit load is there to compensate the existing investors in the fund, then exit load monies should go back into the fund. It's as simple as that really.
However, this rather simple practice is adopted only by Quantum Mutual Fund. All other AMCs Personalfn spoke to disclosed that they employ the exit load monies for marketing and sales promotion activities.
We would like to clarify over here that the exit load monies are not being siphoned off by AMCs to meet marketing and sales promotion activities. It is not like AMCs profess that the exit loads will be reinvested in the fund and then divert the monies for sales promotion.
Rather, AMCs are upfront about how they will use the exit load (i.e. for sales promotion). They are very transparent about the fact that the money will not be reinvested in the fund. We welcome the high level of transparency being demonstrated by AMCs.
Unfortunately for the long-term investor, transparency in this case is not doing him too much good. Instead of being compensated for the erosion in his investments caused by short-term investors, he is reduced to being a mute spectator who must watch AMCs make the most of exit load monies to pay for their own sales and promotion activities.
At Personalfn, we believe the way to go forward on this is that exit loads must be used strictly for only one purpose and that is not to pay for the AMC's advertisements or some mutual fund distributor's trip to the Caribbean. Exit loads must be used specifically to safeguard the interests of the long-term investor and the only way to do that is to reinvest the exit loads in the fund.
Disclosure: Quantum Information Services Ltd. is an associate company of Quantum Asset Management Company Private Limited.
By Personalfn.com, a financial planning initiative. It can be reached at info@personalfn.com. Personalfn.com also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue -- Real Estate & You - please click here.