Good news for mutual fund buyers

The Sebi ban on new fund offers charging initial issue expenses is good news for everyone except distributors.

Everybody Gains: Unless you've been on an inter-galactic mission, it's unlikely that you would have missed the deluge of new schemes from mutual funds. In fact, given the aggressive marketing, a persistent MF distributor may call you on your Iridium even if you're on Mars.

But while intrusive marketing is undoubtedly an interesting story, what's more to the point here is the amazing number of new fund offers (NFOs) made by funds recently.

In 2005, as many as 43 new schemes were launched, mopping up Rs 25,000 crore (Rs 250 billion) -- the highest collection by new schemes in any year. This year, funds have collected more than Rs 15,000 crore (Rs 150 billion) so far. So you may want to invest in some of these new offers.

But before you whip out your chequebook, read this.

Did you know that when you invest in a new scheme, the entire amount isn't invested in the market? You pay charges when you invest in existing schemes, but the charges for new schemes are even higher. That is because Sebi allowed new schemes to spend more on marketing and distribution.

This initial issue expense was meant to help spread awareness of the scheme. But now, Sebi has decided to ban them from charging initial issue expenses. Let us examine why.

Aggressive marketing: Sebi allows MFs to charge a maximum of 2.5 per cent per annum on an on-going basis to meet daily expenses. This means your NAV will get reduced to that extent. Funds can also charge entry loads up-front to the investor, up to a maximum of 7 per cent. Generally, funds charge around 2.5 per cent, which is later passed on to the distributor.

When mutual funds weren't hugely popular, they needed to spend lavishly to promote awareness of new schemes. And since the market needed more investors in MFs, Sebi allowed funds during the NFO stage to spend up to 6 per cent of the amount mobilised, and amortise (write off) this amount over a maximum period of five years. This, by the way, is in addition to the usual 2.5 per cent charge.

In order to show a higher corpus, funds market their schemes aggressively and launch new ones regularly. To do this, many funds pay a higher commission to distributors -- sometimes as high as 5 per cent.

This is way above the usual 2.5 per cent distributors earn from marketing existing schemes, so it's easy to see why they push new funds. Besides, it's always easy to sell a scheme at Rs 10 NAV than an existing scheme where the NAV may be Rs 50 or so. MFs and distributors won't tell you that one is a new scheme fraught with risks and the other is tried, tested and profitable.

Loyalty loses: Some high net worth individuals and corporate investors began milking NFOs by investing in them for listing gains.

As soon as the scheme re-opened for subscription, these investors would make a hasty exit, leaving you, the long-term investor to pay for their actions.

Assume that an NFO collects Rs 1,000 crore (Rs 10 billion). If the AMC maxes its permitted spending limit, it would have spent Rs 60 crore (Rs 600 million) as issue expenses (6 per cent of Rs 1,000 crore).

Now assume that Rs 400 crore (Rs 4 billion) of this was 'hot money', which left within two months. That same Rs 60 crore will be apportioned over Rs 600 crore (Rs 6 billion), of which you are a part, instead of the Rs 1,000 crore. To that extent, more goes out of your NAV.

For instance, JM Emerging Leadership Fund collected Rs 207.67 crore (Rs 2.07 billion) in its NFO in July 2005. At the end of March, its corpus had fallen to Rs 40.9 crore (Rs 409 million). But the fund is yet to amortise Rs 10.90 crore (Rs 109 million) of its NFO expenses.

Even if we assume that the fund's size would have remained the same, it would have had to take a hit of 1.05 per cent (See below: The Lower the Corpus, the Greater the Hit). But with a reduced corpus, the fund will now take a hit of 5.33 per cent for the next six years.

Outlook Money was among the first to tell you that investing in NFOs is a win-win situation for all except you, the retail investor. Mutual funds get to boast a higher collection figure; that has become very important for them these days as every MF wants to be up in the numbers game. Distributors earn more by selling new schemes than old ones.

The large investor makes his gains once the scheme re-opens and he pockets the rebate that his distributor gives him unofficially.

Someone has to pay, and in this case, that someone is you.

The new rules: The good news is that much of this will now stop. Open-ended schemes launched after 4 April (when Sebi released its order), will not be allowed to charge the initial issue expenses. These schemes will have to recover their marketing and distribution expenses from the entry load itself. Only closed-end schemes will be allowed to charge the NFO expenses, which they will write off during their lifetime. But closed-end schemes would not be allowed to charge any entry loads.

Sebi has stipulated that in case of closed-end schemes, if an investor exits before the initial issue expenses are fully amortised in the scheme, the investor will have to cough up his share of the un-amortised amount, in addition to the exit load, if any. Says U K Sinha, CMD, UTI Mutual Fund: "There was an element of inequity in favour of large investors, who would churn their portfolios frequently. This inequity now goes."

Unfinished business? Though mutual funds will now have to recover their expenses upfront, the coming months will tell us how they will manage to do so. Though Sebi allows them to charge a maximum of 7 per cent entry load, most funds charge around 2.5 per cent. Will MFs now increase the load to the full 7 per cent? Most funds we spoke to seem reluctant to do so.

Kavita Hurry, CEO, ING Vysya Mutual Fund, says: "Markets are already used to a certain entry load. I wouldn't think funds would go for a big increase." But none of them are willing to say categorically that entry loads will be untouched and an across-the-board hike of at least 1 per cent seems imminent.

So, that's good news for small investors, but is it good for the fund houses? Most MFs we spoke to have welcomed Sebi's move. They say that though they used to pass on the brokerage costs, they were often almost held to ransom by greedy distributors looking for higher commissions.

Sebi's move benefits fund houses like Fidelity, which does not pass the NFO expenses, if any, on to investors. So you only end up paying the entry load. The move also benefits fund houses like Quantum Mutual Fund, which has deliberately chosen to avoid selling its schemes through distributors. "Distributors should also be regulated so that they don't get away with charging amounts they don't deserve," says Sinha. Perhaps that's the next move for Sebi.

And though the new rule should not stop mutual funds from launching new schemes, expect the number of NFOs to decline. That's because fund houses will launch new schemes mainly to complete their bouquet of offerings.

Mutual fund distributors, particularly the bank-based ones, are also re-thinking their strategies, as they used to earn a big chunk of their revenues from selling third-party products like mutual funds. With competition heating up, market sources say they will revise their targets upwards on existing schemes.

This bodes well for you, the retail investor, as at least now you'll be able to judge schemes fairly by past performance. And, of course, there may be more closed-end schemes on offer, as these schemes are exempt from the Sebi order.

Want to invest in Mutual Funds? Get good advice, join the Mutual Funds Discussion Group