If your MF isn't profitable, how will it make money for you?

The mutual fund business in India is a losing proposition, except for a very few that have already built up a strong asset base. Even the profitable ones are making almost next to nothing on the total asset size.

If mutual funds are not making money, what’s in it for you, dear investor? Table below shows that the most profitable funds of the lot, Reliance and HDFC Mutual Funds, earn post-tax returns of just 0.26 percent and 0.28 percent respectively on total assets under management.

Profitability declines for the rest of the mutual funds steadily, with the 10th ranked fund in terms of assets - IDFC MF - earning a negative spread on assets under management.

More from Investing

Why should women go for a term insurance plan? Low risk, predictable returns & liquidity options - A stable investment opportunity for your hard-earned money

The huge difference between the top three and the rest in terms of profitability throws up the question of how the rest of the pack - there are 44 mutual funds operating in India - will survive and make reasonable profits.

The low profitability of mutual funds also throws up uncomfortable questions to potential acquirers. The valuation of a fund based on percentage of assets under management does not make sense if profits as a percentage of assets are pathetically low at below 0.28 percent levels.

[caption id=“attachment_99926” align=“alignleft” width=“380” caption=“The low profitability of mutual funds also throws up uncomfortable questions to potential acquirers. Ron Sombolin/Flickr”]  [/caption]

For example IDFC paid Rs 830 crore to buy Standard Chartered Mutual Fund. Assuming that IDFC rises up to Reliance MF’s profitability of 0.26 percent and to the size of Rs 100,000 crore in the next three years, the payback period for IDFC for its investment is over six years from now on an extremely optimistic scenario.

Mutual funds making consistently low or even no profits cannot invest for growth down the line. They will find it extremely difficult to attract talent, their sponsors will not have the money to hold on to loss-making vehicles for long periods of time and investors in these funds will suffer.

Lack of good fund management talent and questions on the sustainability of operations will arise. IDFC shareholders have suffered, with the stock underperforming the Sensex by over 25 percent, since the purchase of the mutual fund in early 2008.

[caption id=“attachment_99921” align=“alignleft” width=“549” caption=“Table”]  [/caption]

The even bigger issue facing the mutual fund industry is the complete lack of differentiation in products. Every single fund offers the same products in the equity and fixed income space. The level of service is similar for all funds and the only differentiation can come from performance. Performance comes from hiring good talent and the unprofitable ones will not be able to hire or retain talent.

Globally, talent went out of mutual funds into hedge funds but unfortunately hedge funds catered only to big ticket investors. The retail investor is looking at bleeding returns on investments in funds that just benchmarked performance to equity indices, as the current state of the markets has wiped out decade-long gains in many developed world equity markets.

Investors have to think hard on why they should invest in other funds than the ones that are making good money.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.