Small investors' big-ticket burden

MF expenses are loaded against retail investors.

In the previous two articles*, we discussed how late trading and unfair trade allocation can hurt mutual fund investors, especially small investors. There are several other ways by which mutual funds favour big-ticket investors.

Much has already been talked in the past couple of years about dividend stripping, a mechanism by which large investors can take advantage of the tax-free dividends from mutual funds. So we refrain from getting into the details of dividend stripping here. The other critical area of concern is the expenses charged to larger and small investors.

First, mutual funds charge lower load from large investors compared to the smaller ones. Load is charge levied by mutual funds when an investor steps into a fund (entry load) and/or when he exits a fund (exit load). Loads are normally charged to meet the marketing costs, like distribution commissions and so on, that a fund house incurs.

Most mutual funds charge an entry load of 1.5 to 2 per cent for equity and balanced funds. However, over the past year, most mutual funds have changed the rules of the game. They now follow a differential load structure. Now many funds offer big investors entry into funds without any load or have a progressive load structure.

In other words, the more the amount invested, the lesser the load. What is even more ridiculous is that fund houses charge differential loads even for redemptions (see chart).

For instance, in the case of Alliance Income, Birla Income Plus, Prudential ICICI Income Fund, Principle Income Fund for amount less than Rs 10 lakh redeemed within six months, the exit load is 0.5 per cent.

For higher amounts the exit load is either nil or 0.25 per cent. HDFC Income Fund and Templeton Income Fund charge an exit load of 0.5 per cent if units are redeemed within six months for investments up to Rs 10 lakh.

However, for larger investments the exit load is applicable only if units are redeemed within three months and that too at lower rates. Other medium-sized funds like Tata, JM, Sundaram, SBI and Reliance also follow similar load structure with cut-off slabs being lower.

The idea of exit loads is to ensure that investors do not take a short-term view on the fund and pull out their money impatiently. The fact is that in case of open-end funds the fund corpus keeps fluctuating. This is because investors keep stepping in and out.

However, too much fluctuation in a corpus can make life difficult for fund managers and drags down returns as a fund manager is forced to hold a larger proportion in cash for fear of redemption. Unanticipated redemptions can also force a fund manager to dump stocks in the market without realising the best value for the holdings.

Besides, big-ticket investors tend to track performance of funds very closely and pull out money at the drop of a hat. A slight deterioration in performance of a fund or signs of change in interest rates or equity outlook can drive them to pull out money.

This causes unnecessary volatility in the fund's corpus and forces fund managers to churn their portfolio more often. So, funds with a high component of institutional money tend to have higher portfolio turnover leading to higher costs that eat into returns. Needless to say, the exit of a large investor from a fund can have a destabilising impact. In contrast, redemptions by small investors can seldom have a similar impact.

Going by that logic, the former should be penalised or made to pay more for the damages caused to a fund. However, mutual funds' policy of levying an exit load for small investments while allowing large investors to redeem units without any charge defies all logic.

That apart, retail investors are also charged higher investment management fees. In most cases, the investment management fee charged by the asset management company (AMC) for institutional plans is half that of the fee charged for retail plans. The worst part is that both the institutional and retail plans of mutual funds are managed as a single fund (except in the case of one or two fund houses like Templeton).

In other words, the money collected in the institutional plan and the retail plan is pooled in, and the underlying portfolio for the two plans is the same. Even as the fund is managed by the same fund manager and the two plans have the same portfolio, institutional investors are charged a lower fee.

One direct consequence is that unlike in equities, in debt funds investment (where institutional plans are common) management fees can make a significant difference to returns. With interest rates having bottomed out and debt fund returns expected to settle down in the range of five to six per cent, management fees will start telling on the performance of these funds very soon. It needs to be remembered that institutional money tends to be volatile and every time a large investor pulls out, the existing small investors have to bear the brunt.

There are other soft issues that affect small investors. For instance, some funds disclose their portfolios almost on a daily basis to big-ticket investors. However, the retail investor has access to the portfolio only at the end of the month. Whether it is account statements or redemption cheques, retail investors get step-motherly treatment.

The Securities and Exchange Board of India (Sebi) has now mandated that every mutual fund scheme should have at least 20 investors and no single investor can hold more than 25 per cent of the corpus. In the event of violation of this rule, the schemes would have to be wound up.

The issue is not about mutual funds managing institutional money. The real issues stem from clubbing retail investors and institutional investors together in the same fund. How can investors "" with completely different objectives, time horizons and expectations "" be tied together in the same fund?

Looked at in this light, even the 25 per cent ceiling appears to be to on the higher side. There should be separate plans for retail and institutional funds and in the retail schemes no single investor should be allowed to hold more than 10 per cent of the corpus.

These schemes should be managed separately to ensure that the large investors do not cause any damage. Management fees could be lower for institutional players. After all, anywhere in the world for any product, there are discounts for wholesale purchases. But then, the fee for retail investors should not be unrealistically high.

If there is a demand for fund management from big-ticket institutional investors, there is every reason to cater to that demand. Considering the apathy of retail investors towards mutual funds, if anything has kept the mutual fund industry going, it is the institutional money.

Right from the cost of acquisition to investor servicing, retail accounts are a lot more expensive. It's not surprising that mutual funds are loth to go all out to service retail investors. Many players feel that setting up branches beyond the four metro is quite a challenge to justify.

So, institutional money is important for mutual funds to survive till the time retail investors are comfortable with the idea of fund investing.

* "For mutual funds, it's never too late"( December 1) and "The hidden subsidy in mutual funds" (December 8).