The Hindu Business Line : MFs must discourage short-term investments

MARKET timing is an important factor that determines short-term returns in direct investing. Institutional investors and high net worth individuals (HNIs) extend this strategy to mutual fund investments as well. Such redemptions hurt unit-holders who stay invested in the fund.

The primary reason these investors' time the market is that funds encourage such practice through differential and favourable load structure. Typically, funds waive exit load, and lower entry load for high value investment.

SEBI should encourage funds to have a higher load structure and also frame rules that will make the institutional investors and HNIs bear the cost of early exit. The reason is that market timing goes against the concept of investing in mutual funds, which are typically long-term investment vehicles.

Differential loads: Take IL&FS Bond Fund. The fund waives exit load if the investment is above Rs 10 lakh; retail investors suffer an exit load of 0.50 per cent of the net asset value (NAV) if they redeem within 180 days of investment.

The differential load structure is not confined to just bond funds. The IL&FS Growth and Value Fund, for instance, charges an entry load of 0.50 per cent for investments between Rs 25 lakh and Rs 2 crore, and waives load for investment above Rs 2 crore; retail investors suffer 2 per cent entry load. Other fund-houses are no different.

Considering that mutual funds are primarily long-term investment vehicles for retail investors, it seems unfair that this class of investors has to bear the cost of early exit of institutional investors and HNIs.

Impact cost: When investors move in and out of a fund at short intervals, the existing unit-holders, mostly retail investors, suffer high impact cost. This refers to the cost suffered by the unit-holders because the fund has to sell large quantity of shares in the market to redeem units.

Suppose Pidilite Industries trades at Rs 325, but the stock moves down to Rs 320 after the fund sells, say, 10,000 shares. The Rs 5 decline in price is the impact cost that the existing unit-holders bear because the fund sold shares to redeem units.

Since institutional investors and HNIs move large sums of money, the impact cost is likely to be high. Investors are not aware of this because impact cost is really an opportunity cost. For instance, the fund may have generated 15 per cent returns instead of 12 per cent if it had not sold shares to meet an HNI's redemption request. That is, of course, difficult to measure.

The alternative is for the funds to have more cash on hand to meet the redemption requirement. But that leads to cash drag. Suppose an equity fund earns 15 per cent, but has 10 per cent of its portfolio in cash equivalents that earn just 2 per cent return. The cash drag is 1.3 per cent (15 per cent minus 2 per cent multiplied by 10 per cent). Encouraging short-term trading, therefore, results in an impact-cost - cash-drag trade-off.

Suggestion: SEBI should encourage fund-houses to charge a higher load to discourage short-term investment. Such a load structure can be based on two parameters- investment horizon and redemption value. If the investment horizon is shorter, the load structure should be higher. This will deter any investor from timing his or her exit. To further deter institutions and HNIs, the load structure would be steeper for higher redemption value.

But even that may not stop this class of investors from indulging in short-term investment, if returns are higher. SEBI should, therefore, encourage funds to structure rules so that this class of investors bears the impact cost. A fund can, therefore, move the proportion of the portfolio that belongs to an institutional investor to a separate account, and then sell that portfolio to meet the redemption requirement.

Suppose a bond fund has a total asset base of Rs 350 crore, invested in 10 bonds of Rs 35 crore each. If an institutional investor redeems Rs 35 crore, one-tenth of the total asset size, the fund has to move one-tenth invested in each of 10 bonds to a separate portfolio. The fund can then sell the assets in that portfolio and redeem the units of the institutional investor. This rule, of course, requires a minimum redemption value; otherwise, it may be sub-optimal for funds to sell assets (stocks and bonds) in smaller lots in the market. Such rules may discourage short-term investments. And that will enable mutual funds to deliver optimal returns to long-term investors.

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