Are Indians becoming more tolerant of failure? Recent events suggest so, with dozens of new tech enterprises starting up and going bust at a lightning speed. The government too is working on a new bankruptcy code that will allow businesses which are unviable to be quickly wound up instead of limping along for years. It would be nice if the mutual-fund (MF) industry took a cue from this to admit to failures too.
No, the suggestion here is not that small fund houses (which haven't managed to win the AUM race) should wind up their operations. Instead, the reference is to the many underperforming schemes, which even the leading fund houses manage, that have lagged their benchmarks and peers for many years.
Then there are the schemes that have proved plainly bad ideas for investors. We all know of several thematic-fund ideas that have flopped big time in recent years - technology funds in 1999-2000, India reform and infrastructure funds in 2007-08, PSU funds in 2009-10, etc. Having been launched when the said theme was greatly fancied, we know that their long-term record is unlikely to ever match that of good diversified funds. This apart, there are other fund categories too, that haven't proved great fits for investors - monthly-income plans, capital-protection funds, equity-plus-gold funds, tactical-asset-allocation funds and so on.
Admitting that these schemes haven't delivered, winding them up would be the best course of action for investors, but hardly any fund house in India is actually willing to do this.
Why NFOs?
In recent weeks, the SEBI has clamped down on its approvals for new fund offers and has been asking fund houses that manage a long laundry list of schemes to first consolidate and merge older schemes before launching new ones. The SEBI has sound logic backing this stricture. The MF industry, it has said, already manages some 2,200 schemes, 900 of them open ended. These schemes already offer every possible choice on investment styles, strategies and market-cap orientation to investors. Therefore, what can NFOs offer that is genuinely new?
There is merit in this view. One of the key reasons why a first-time investor hesitates to approach the MF vehicle (apart from irritants such as KYC, of course) is the vast and bewildering menu of funds offered by the fund industry. Then why isn't the industry acting to merge and consolidate similar schemes?
Well, there seem to three reasons for this reluctance. One, until recently it was quite a tricky proposition for a fund house to merge similar schemes because of the tax regime in force for fund mergers. When one scheme merged with another, investors in the merging scheme were forced to pay capital gains tax on the switch as if they had redeemed their scheme. But as investors actually don't book any profits on mergers, this tax incidence was unfair. But complaints on this score by the fund industry has prompted the SEBI to take up the issue and the finance ministry has clarified, in its 2015 budget, that fund mergers would not be treated as redemptions and thus would not be chargeable to capital gains tax.
Still reluctant
But even after this tax tweak, there has been no rush to merge similar schemes or consolidate them. This brings us to the second reason why MFs hesitate to shrink their large menus of products. When a fund house decides to merge schemes, there's a long winded process involved. The move has to be approved by the regulator and the board of trustees, the merger terms have to be worked out and unitholders in both schemes need to be given an exit option. Now, most fund houses are wary of the last step. Often investors in poorly performing MF schemes hesitate to book losses. Or they bought the fund long ago, have locked it away and have simply forgotten about its existence. In such cases, sending an intimation to investors on a merger with an exit option can lead to the AMC losing assets. Why would fund houses do this, when their own fees are linked directly to the AUM?
They like it long
Three, AUM apart, fund houses also have other vested interests in managing multiple schemes with similar mandates. Running dozens of schemes in each category acts as insurance for the fund house against poor performance. When a fund house manages literally dozens of equity schemes - designated as growth fund, equity fund, equity-opportunity fund and what not - it can count on at least one or two of its schemes always figuring in the top quartile of the performance rankings. As long as one or two of the schemes are in the top quartile, the fund house can promote them widely as 'flagship' funds and hard-sell them to distributors and investors. Other middling performers from the same house can quietly be ignored. In contrast, a fund house which manages just one or two schemes in each category would be under far greater pressure to deliver performance. This is yet another reason why fund houses aren't all that keen on consolidation.
However, when fund houses stall scheme mergers for the above reasons, it is clearly against the interests of investors - both in the existing schemes and in new ones. As long as fund houses continue to confront new investors with a bewildering menu of products, first timers will continue to think that MFs are a complicated product that they should give a wide berth to. And as long as poorly performing old-timers drag on, the return experience of investors in those duds will never improve. That's why the SEBI needs to take a tough stance on not approving NFOs from fund houses which manage scores of also-ran schemes.
In fact, instead of insisting that smaller and lagging schemes be merged, the SEBI should probably insist on MFs winding up such schemes altogether and admitting to their investors that the idea hasn't worked as they initially thought. After all if NFO roll-outs must be accompanied by such hard-sell and heavy-duty promotion, there's no reason why fund houses should get away with sweeping such schemes under the carpet and not even notifying investors when the idea hasn't worked.
This article was originally published on January 14, 2016.
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