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Five Tectonic Shifts

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This last year has been a momentous one for mutual funds. More has changed for the mutual fund community since early 2009 than had changed in perhaps five years before that. These changes range across how funds are launched, how they are sold, and how they are run. From fund companies to distributors to investors, everyone has been impacted by these changes. Five or ten years from now, these changes will ensure that we end up with a very different mutual fund industry than we would have had these changes not taken place. Here are the five big changes that have happened: by Dhirendra Kumar
No Early Redemption For Closed-End Fixed Maturity Plans (FMPs). In India, we have two distinct mutual fund industries, each with its own business model. There is the equity and hybrid fund industry that serves individual investors, and there’s the fixed income funds industry that provides corporates and banks a place to park spare funds in the short term. In a very real sense, this part of the business serves as a substitute for the bond market that India does not have.
However, the 2008 credit crisis exposed two deep flaws in the most popular fund type in this segment — fixed maturity plans (FMPs). FMPs are closed-end funds that are used as alternatives to fixed deposits — they offer higher returns and lower tax levels than fixed deposits. However, before 2008, they were not true closed-end funds. To comply with a rule that requires fund companies to offer liquidity, these funds offered premature exit. When the credit crisis broke in October 2008, investors exercised this option. However, funds found that under those circumstances, it was impossible to sell any of the underlying securities at anything close to the values on which the net asset value was based. Effectively, the early redeemers walked away with more than their fair share of money.
In response to the crisis, Securities and Exchange Board of India (Sebi) forbade this ‘early redemption’ route. It rules that funds’ FMPs must offer premature encashment only by the listing on the stockmarkets. However, low volumes and big discounts prevent listing from becoming a viable exit option. In effect, closed-end FMPs are now genuinely closed-end.
Liquefying Liquid Funds
Fixed-income investment — whether through funds or directly — is based on the premise that the maturity of the debt instrument governs the risk and return levels. Investments that are close to maturity have lower risk but potentially lower returns. Investors who want safe returns must stick to bonds that are about to mature. And fund managers must stick to bonds whose maturity mirrors the investment period and the risk expectation of the fund’s investors.
Unfortunately, benign and risk-free times encourage investors and investment managers to stretch these limits only to come a cropper when risk levels suddenly shoot up. This is what happened during the financial crisis. The culprits were liquid funds and the so-called liquid-plus funds.
These funds are typically used by companies as a substitute for bank deposits. Typically, they earn a little more than bank deposits and are more tax-efficient. The underlying investments that these funds make are chosen for safety and, obviously, liquidity. Liquid funds invest in debt instruments that have a very short maturity. The ultra-short term means that these instruments have very low risk.
Liquid plus funds are a variation on the liquid fund theme. Liquid plus funds are somewhat riskier, but at the same time they offer slightly higher returns and are subject to lower taxation. Dividend distributed by liquid plus funds is subject to an effective tax rate of 22.7 per cent, while plain liquid funds’ dividends are taxed at 28.3 per cent. Coupled with the slightly higher returns, this makes a big difference to companies that are parking huge amounts for short periods of time.
Unfortunately, the higher returns come at the price of higher risk. Liquid plus funds invest in instruments that have a longer tenure and are, therefore, subject to more risk. For a long time, this risk appeared to be merely theoretical. However, in these times of global risk-aversion, this risk has become real.
In response, Sebi banned the term ‘liquid plus’ and forced liquid funds to ensure that the maximum maturity of any of their securities was less than 90 days. This change was gradually implemented through the first half of 2009.
Abolition Of Entry Load
The biggest change that hit the mutual fund industry during the year was the abolition of entry load. At one (sudden) stroke, Sebi consigned large part of the fund industry’s business model to the garbage bin. The regulations issued by Sebi in July 2009 sort of completely transformed equity fund investing in India within a month. These changes effected a wrenching change in the business practices (and perhaps even business design) of fund distributors and fund companies.
As every mutual fund investor must know by now, Sebi has abolished entry load on mutual funds. Entry loads, generally around 2 to 3 per cent, were deducted by fund companies from the investment in order to pay commission to the fund distributor. This upfront commission was one of the two main payment streams from the fund to the distributor, the other being the so-called trail commission, which is paid at a rate of about 0.75 per cent per annum. However, the upfront commission is effectively the biggest factor behind bad advice given to equity fund investors. This commission structure means that it is in the fund distributors’ interest to continuously make you sell your existing holdings and buy something else. This ‘churning’ was rampant in the fund industry. Distributors of all sizes and scale from the soloist in your neighbourhood to the big banks’ wealth management units were guilty of this. The idea behind these changes is to stop this. Sebi’s new rules stipulate that the distributor will be paid directly by the investor whatever amount the two settle between them as a fair payment for services and advice rendered.
This system has been in place for almost six months now and the results are mixed. It appears that many distributors, instead of selling mutual funds without commissions, have switched to pushing Ulips (unit linked insurance polices) on to their clients. Sebi’s good intentions of lowering costs has diverted the market to a complex and opaque product, which has much higher costs and commissions than mutual funds.
Bringing In Digital Distribution Platforms
Mutual fund distribution in India is still a cumbersome, manual process. That sounds surprising because investors do get neat, computerised printouts from their fund companies. However, this impression of automation is an illusion. Almost all fund purchases start with a paper form that is filled in by hand and the data is punched in by hand. Investors’ data exists in separate islands in each fund company, and more often than not, even the same fund company cannot connect the dots, and treats different investments from the same investor as from different investors.
This cumbersome process is limiting the spread of mutual funds because absorbing and managing the physical inputs requires a physical presence, and fund companies and their registrars are present in only about 300 towns and cities. For a long time, it has been recognised that wider spread of funds could occur only if access and cost could be controlled by having a digital transaction platform that could be accessed over the Internet.
There has been talk of the mutual fund industry creating such a system also for a long time now. The project was to be run under the banner of AMFI (Association of Mutual Funds of India). However, by late 2009, it became clear that the project wasn’t going anywhere. 
Many smaller fund companies suspected the larger ones of backpedalling on the issue because on a relative scale, such a platform would reduce the advantage that firms with large retail networks have. In November 2009, Sebi expedited the process by asking the two exchanges to extend their IT platforms to handle mutual fund transactions as well.
This does extend the network to about 200,000 terminals across 1,500 locations. It also has the potential to lower costs, although it isn’t yet clear by how much. However, it is still early days yet. The exchange systems are up and running but have very little volume yet. Still, unified, cross-fund digital platforms are an important part of the future of mutual fund investments, and the first step has been taken.
Advent Of The New Pension System
The New Pension System (NPS) is not a mutual fund but is sufficiently similar to one to play a part in the future of fund investing. The NPS is, of course, the ultra-low cost pension system that is expected to revolutionise and take over retirement savings in India. As such, the NPS is a retirement solution and not an investment avenue. However, the NPS includes within it a second type of account that does not lock in your money till you reach retirement age. These ‘Tier II’ accounts are very close in function to normal mutual fund investments, except that they have the same low-cost structure that the Tier I retirement accounts have. Effectively, the NPS Tier II is a conservative balanced fund, and can be treated by investors as such. However, from a sales point of view, the fact remains that the NPS is nobody’s baby. No one is interested in selling it and you’ll never be approached by an NPS salesman because such a creature doesn’t exist. The NPS’s success depends on whether the government ever replaces the EPFO with it, but for a knowledgeable investor, it is certainly a serious option. 
However, Budget 2010 has demonstrated that at some level, the government is serious about pushing the NPS and is willing to innovate to do so. In what must be a first of its kind, the government will basically give a gift of Rs 1,000 per year for three years to small depositors joining the NPS. This scheme is open only to those who deposit less than Rs 12,000 per year and start their account in 2010-11. This is an interesting instance of paying a direct subsidy in a way that is designed to encourage people to save. Since the NPS is a pension system, the money is not available till it is usable as a pension on attaining retirement age. For a young person, this Rs 3,000 welcome gift from the NPS would grow manifold till the retirement time comes.
The author is chief executive of Value Research
(This story was published in Businessworld Issue Dated 15-03-2010)

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