Equity Funds, RIP? India needs pension funds, not MFs

On 26 June, the Confederation of Indian Industry organised a mutual fund summit in Mumbai with Sebi chief UK Sinha in attendance. Its main conclusion: growth is currently confined to the big cities (Tier-1) and the industry must now focus on smaller towns and “untapped” markets.

It’s a pointless exercise and won’t yield much. It goes against common sense to suggest that when investors in big cities are unwilling to invest in mutual funds, those in smaller towns will. Unless the assumption is that they will be easier to gyp for a while.

The only thing that will get Indians to buy mutual funds - especially equity funds - is performance, and of that there is very little sign. In fact, the vast majority of funds have done no better than banks deposits - which means they have probably destroyed value after adjusting for inflation in the medium term.

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A casual perusal of the Mint 50 list of “best funds” today tells us that the best three-year returns from large-cap, large-cap plus mid-cap, and multi-cap funds is 7.01 percent for the ICICI Pru Focused Blue Chip Equity Retail. Returns are higher once we go to mid- and small cap funds - where the highest fund, SBI Magnum has returned 13.51 percent - but this has probably come by courting higher risk.

This is no better than debt funds, which the best funds in Mint’s list delivered 6-9 percent over three years, and around 9-13 percent over a five-year period, which would have taken both high-interest rate and low-interest rate periods in their stride.

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In equity, double-digit returns in the range of 10-15 percent are visible only over five years. It is only when you look at 10-year returns that you see equity really producing great returns, with the best funds doing 23-25 percent.

What this shows is simple: but for the huge lift from the pre-2008 liquidity-driven bull market, Indian mutual funds would have barely performed better than fixed deposits and debt funds. Where they have done better, they have perhaps risked the investors’ shirts to do so.

Why, then, should investors think of equity mutual funds at all?

Debashis Basu, writing in Business Standard today, raises this question and says that when investors do not see clear benefits and when the process of buying or choosing a mutual fund is so complex, the industry is unlikely to grow. He writes: “Mutual funds are like a car company that ships out completely knocked down self-assembly parts, some of which are unreliable. The customers are supposed to figure out - without a manual - how to assemble the parts to ensure a workable product. Look at it this way and you realise why the current mutual fund model is doomed to limp along.”

He’s right. The truth is mutual funds seem to find traction only in fair weather - when the markets are anyway booming, as during the 2003-08 period. And as of now, there is nothing in their returns to make a song and dance about. Moreover, they seem to require the lift of at least one big boom - unrelated to stock-picking skills - to show outperformance over fixed deposits and debt. Despite the low returns from debt, long-term debt funds at least have the tax advantage of being able to adjust for inflation while calculating capital gains.

So why have an equity mutual fund industry at all? Why not make them an adjunct of the pension fund industry?

This writer believes that passive investing through index funds is a good enough proxy for those who want to take the dive into equity; for the rest, the right route for getting into equity should be through the earmarking of a portion of pension funds for long-term investing in equity.

This way the high costs of marketing mutual funds to retail investors are avoided, and there is also an in-built ceiling on how much of the corpus will be risked in the chase for higher returns through equity.

As this writer has noted befor e, there is strong evidence the world over 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 profitable opportunities so quickly.

The fact that 10-year mutual fund performance in the Mint 50 is better than the three- or five-year performance is another argument in favour of letting retail investors get into equity through long-term pension funds rather than mutual funds.

Equity mutual funds can close show and no one will know the difference.