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Money Jul 2, 2012

Why pension funds may be better for equity than MFs

By R Jagannathan

Sebi wants to protect mutual fund investors from non-performers. Among other things, it wants to deny underperforming mutual funds the right to launch new schemes in future.

Next, it wants to bring back the entry load - the upfront fee charged to investors that funds earlier used to pass on to distributors who could bring in investors. Sebi had banned it some years back, and the mutual fund industry has been busy attributing the drop in business to this one factor.

In both cases, curbing underperformers and allowing entry loads, Sebi is barking up the wrong tree. The world over, some two-thirds of mutual funds underperform the market primarily because they are the market. The share volumes they need are held only by other funds - which means a smart buy decision made by one fund amounts to a dumb sell decision by another. Net result: the industry as a whole seldom outperforms the indices consistently.

If pension funds are mandated to invest initially only in debt, and only half of debt earnings can be further invested in equity from year two, investors will get capital protection and equity-led growth. Reuters

If Sebi's logic were to rule globally, half the funds should be shut down.

Nor is the return of the entry load going to solve mutual funds' problems of shrinking investor bases and corpuses. The entry load is essentially a deduction from the money entrusted by the investor to the fund. So on Day One, the load reduces the value of her initial corpus to something less - even before the investment starts working. A marginal entry load of, say, 0.25-0.3 percent of investment may be fine, but anything higher is robbery.

This does not mean Sebi should not be concerned about how investor funds are performing, but it must look at the Indian situation based on where we are in terms of market and investor maturity. In fact, in India there is a good case to be made for making pension and provident funds the primary vehicles for equity investment, rather than pain vanilla mutual funds.

Consider these realities.

First, currently investors seeking an indirect entry into equity have perforce to use mutual funds. Barring investors in the New Pension Scheme (NPS), provident and pension funds are barred from investing equity.

There is strong evidence that pension funds investing in equity outperform mutual funds because their fee structure is low, and their funds are long-term in nature. According to Jason Zweig of Money Magazine, there is a simple explanation for this: mutual funds cost more than pension funds to run. He writes: "Mutual funds charge more because they cost more to run. A pension fund doesn't have to advertise how great it is, maintain a 24-hour toll-free phone bank or mail out tens of thousands of prospectuses."

In India, the fees payable to fund managers of the New Pension Scheme are lower than those payable to mutual funds managers- even though the two are often the same.

Moreover, pension funds do not face sudden surges in inflows or outflows - they are long-term funds meant to build a corpus for employees when they retire. Mutual funds, in contrast, are open-ended investment vehicles - they can see huge inflows or outflows, and both are bad for performance. A fund that got lucky in one quarter may see a surge in inflows and its performance after that will usually fall since so much money will not find profitability opportunities so quickly.

Ditto when outflows happen. As a fund manager keeps selling stock to make his redemptions, the stocks being sold could fall in value, reducing his performance even more.

Pension funds managers, on the other hand, have greater funds stability. In India, the equity-linked savings schemes (ELSSs), which have a three-year lock-in, tend to perform better than completely open-ended funds precisely because there is greater stability. Over the last one year, for example, diversified funds fell 5.8 percent in India, while ELSS schemes fell 4.9 percent. Over two years, diversified schemes lost 1.2 percent and ELSS 1 percent, and over three years, both managed a positive 8.5 percent.

Lesson 1: Pension funds have to become the prime vehicles for equity investment. This is the policy change we require. However, even here there are easy ways to take the risks out and quell investors' fears in a bear market. For example, if pension funds are mandated to invest initially only in debt, and only half of debt earnings can be further invested in equity from year two, investors will get capital protection and equity-led growth.

Second, the second structural reason why mutual funds in India are the wrong vehicles for retail investors is the huge amount of mis-selling that happens in all financial products due to a vicarious sales incentive structure. Mutual funds, pension funds and insurance companies are governed by three different regulators, and each one has his own approach to fees and entry loads. It is easy to push products in which distribution fees are higher, but this is precisely why mis-selling happens.

For example, why should insurance agents get 20-40 percent commission on the first year's premia when mutual funds have no entry loads at all? How can anyone sell mutual funds if insurance companies can hawk unit-linked insurance plans as investment products?

The answer cannot be that insurance is different from mutual funds. The difference exists only between term insurance - where no investment product is on offer - and mutual funds, but not when insurers sell money-back schemes or unit-linked insurance plans (Ulips). Clearly, the finance ministry needs to bash heads together and get some sense into the system of paying distributors and agents in these different, and yet not-so-different, financial products.

Till that happens, mutual funds are no-hopers.

Third, there is also a problem of wrong expectations among mutual fund investors. All equity investors are sold two partial truths: that, in the long-run, equity will always outperform other asset classes; and that timing of entry does not matter. And they are not told the one universal rule in investing: separating what they are willing to risk from what they are not.

The problem is in defining long-term - which is entirely specific to the investor. At age 25, 20 years may not look like long-term. At 55, even five years looks like long-term. In view of this, timing of entry is important for mutual funds. Unless one is regularly investing through systematic investment plans (SIPs) over bull and bear cycles. Pension funds work precisely because they are forced SIPs.

Moreover, no matter what tenure one is willing to see as long-term, equity will outperform other asset classes only if there is a continuous increase in liquidity and inflows into the equity markets relative to available stocks.

All prices depend on demand and supply. Unless money inflows exceed available stocks, share prices cannot really rise. In India, stock prices can become vehicles of long-term wealth creation if we can assure a continuous flow of long-term funds - once again, this means pension and retirement funds. Currently, our market liquidity depends entirely on foreign institutional investors (FIIs), and not domestic investment. This is why our booms and busts are overly dependent on foreign investor moods.

The other reason why investors are psyched out by mutual funds is asset allocation. Most investors come to mutual funds because they are promised higher returns in equity, but they are not told about asset allocation: that equity is the part they should be willing to write off after preserving their core investments in debt or other avenues.

Once again, this is the main reason why pension funds are a better way to get ordinary folks into equity than mutual funds. Pensions funds, even when they offer higher equity allocation options, force savers to compulsorily make an asset allocation choice.

Maybe, Sebi should fret less about mutual fund performance and lobby instead with the finance ministry to create more pension-fund-type products for the long term with longer lock-ins like ELSS.

by R Jagannathan

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