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Close ended Fund NFOs
THERE are a lot of questions around closed-ended funds, with investors asking why every fund is launching these. Analysts are saying that these funds are opportunistic and harmful for investors. Distributors like the commissions, but they are worried about rapid product proliferation. Asset management companies are ruing the need for such tactics, but are launching one product after another to get assets. The return of closed-ended funds is actually a clear and unambiguous signal that the kind of regulation attempted in the past five years has not solved the real issues of investor protection against mis-selling, or of acceptance of mutual funds by a larger audience. It has, instead, spawned desperate measures to gather assets.
The investor still gets a product that will enable participation in a diversified portfolio, managed to a process. In the toxic scale, these products will score quite low compared to the low-return endowment or high-cost Ulip, or an opportunistic sector fund. The expenses are limited by regulation and, even after including premium incentives for smaller cities, will not exceed 2.8 percent per annum.
Why are these being launched, especially now, when the equity markets seem to have gone up sharply?
The sad, but simple, answer to this question is that the existing performing funds do not attract investors as much as they should. The money mobilised by launching closed-ended funds is due to the incentives offered for selling them.
Will an existing fund with a good track record not perform as well as the new fund? Yes, it will, but the seller of such a fund will only earn a trail commission. This is the commission paid to a distributor on assets that remain with the fund. He will earn, say , 0.5 paisa to `1 per `100 of assets every year, in such funds. This is `500 to `1,000 for assets worth `1 lakh. Obviously , it's a small incentive.
How is a new fund different? If the fund launches a new closed-ended product, say , of three years' maturity, the money is expected to stay until maturity . So the fund house will discount the future commissions and pay it upfront on the fund mobilised by the distributor. Instead of earning `1 every year, the distributor can get `3 on a closed-ended fund. This is called the front-ending of commissions, a practice that has spread from the insurance business, which would front-end 15 years' premium and pay it in the first year.
Is the front-ending of commission necessarily beneficial? Not always. In a mutual fund, the upfront commission is paid on the amount mobilised, while the trail is paid on the market value of assets. If the fund performs well, the distributor will be able to earn a higher income, participating in the success of the fund. The trail is, thus, expected to serve as an incentive that urges a distributor to choose good quality funds for the investor. But, distributors think that a rupee today is better than a rupee tomorrow. So they prefer the money upfront, pushing up sales of new closed-ended products over the existing open-ended products.
What is wrong with the closed ended funds? The product is as defined in the regulation and Sebi approves these launches as they follow the book and rules for disclosures. The fund houses get the money they need, the distributors earn commissions, and new investors get a product they ostensibly understand. The problem is that the new wave of closed funds is a repeat of mistakes perpetuated by regulators, fund houses and distributors, and will harm the long-term development of the mutual fund industry . It is a symptom of the larger problem of why a good product like a mutual fund is not as big as it should be.
The simple truth in any business that involves sales is that commissions are the biggest incentive. We may like distributors to be experts, who guide and guard their investors, but even the best in business needs money to survive. The regulators assumed that the new investment adviser regulations would convert the distributors into fee-earning advisers. The problem on the ground is that someone who has built assets of, say, `10 crore will not give up the trail commission of `10 lakh a year, only to scrounge around for fees. Unless regulators see this business reality , the investment adviser guidelines will remain a noble idea.
In an open-ended product, there is no scope of front-ending a trail commission since the fund house will not know how long the investor may stay . The regulators may be unwilling to cede this point and enable a lock-in. They will frown on any attempt to deny investors liquidity and flexibility . The result is the proliferation of closed-ended funds. The return of a fund should depend on the portfolio, but in a series of closed-ended funds, this would depend on the time of launch.
The crux of the problem is the adequacy of commission once we accept that commission is needed. What if regulators gave investors the choice of a voluntary lock-in period? What if the fund houses seek 10-year SIPs in their existing, performing diversified products, with high penalties for premature closure? What if funds allow investors to choose the maturity date of their folio, committing to invest over time for a long-term goal? Unless the regulators and the industry are willing to sit down and agree on what can be given to investors, and what can be taken away instead, we may not find a solution. By being adamant about what investors should get, we seem to have effectively denied much more to investors. The resulting tactical and clever practices become even more tough to regulate, more so when they follow the book in letter.
The industry needs alignment with long-term goals of investors. Without this, there is no case for the avowed fee-based advice. It should be profitable for the distributor and the fund house to showcase a smaller set of products that competes on performance. A 3-year closed ended fund series is far removed from this principle. Regulators may be keen to bring an end to the closed-ended saga if they continue to receive flak for this proliferation, but they must put the alternative in place.
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