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Monday, Mar 15, 2004

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Short-term investment is long-term bad for MFs

B. Venkatesh

THE Securities and Exchange Board of India is planning measures to encourage retail participation in mutual funds.

This is ironical because mutual funds as an investment option were primarily structured for retail investors.

That institutional investors have used this vehicle to take advantage of the short-term fluctuations in asset prices is indeed unfortunate.

The measures should be structured so as to actively discourage short-term investments in funds that have long-term objectives. This would mean changing the structure of the fees charged by Asset Management Companies (AMCs) and imposing high exit loads on short-term investments.

Industry structure: At present, AMCs earn their fees as a percentage of the total assets managed. Such a fee structure provides an incentive for the AMCs to increase their asset size. And that means luring companies and high net-worth individuals (HNIs) as investors.

The problem is that companies and HNIs are primarily short-term investors.

The frequent entry and exit of this class of investors hurts portfolio returns because of the cash drag. In effect, retail investors who stay with the fund bear the cost of frequent entry and exit of this investor class.

As a first step towards encouraging retail participation, AMC fees should be partially based on the fund performance. This would discourage fund-houses from actively seeking wholesale money for funds that have long-term objectives.

Long-term outlook: Short-term investment in a fund that has long-term objectives should be discouraged. An appropriate measure would be to penalize unit redemptions that are not held for the long term.

Perhaps, a five-year investment horizon can be considered long-term because it is an average time during which a market experiences a bull and a bear phase.

An exit load should be charged on units not held for at least five years. The load structure should be related to the impact cost that the portfolio has to bear due to early redemption. The impact cost of each stock is available on the BSE Web site.

Suppose a portfolio has, say, 25,000 shares of Bajaj Auto, 50,000 shares of Reliance Industries and 2 lakh shares of Satyam Computer. The average impact cost of these stocks are 0.14 per cent, 0.06 per cent 0.08 per cent respectively (Source: BSE Web site).

The mean portfolio impact cost is 0.08 per cent. This is simply the weighted average impact cost of the portfolio.

That is, each stock is multiplied by the quantity of shares and its average impact cost.

The total impact cost is then divided by the total portfolio value to arrive at the average portfolio impact cost. A fund has to typically charge the average portfolio cost as the exit load.

Liquidity versus short-term investors: There has to be a distinction between unit-holders who redeem earlier because of liquidity requirements and others who redeem because they are taking short-term profits.

The reason is that the former is a class of investors with a long-term horizon but need to redeem earlier because of urgent need for cash inflows.

Penalising liquidity and short-term investors with the same exit load may discourage certain long-term investors from buying units in mutual funds. Of course, mutual funds will find it very difficult to distinguish liquidity investors from the short-term ones.

The differential measure needs to be structured keeping in mind the fact that short-term investors are HNIs and companies. Perhaps, mutual funds can keep a threshold of Rs 10,000, the average minimum investment in funds, above which redemptions will be considered as short-term investment.

Redemption of up to Rs 10,000 can be charged the mean portfolio impact cost as exit load. Redemption above that level can be charged a load of portfolio impact cost plus 2 per cent to compensate the long-term investors for the frequent entry and exit.

Companies that invest above Rs 1 crore need not be charged an exit load. Suppose a portfolio size is Rs 100 crore and a corporate investor has units worth Rs 10 crore.

The portfolio manager can move one-tenth value of each stock into a separate account, sell the shares and redeem the units. This way, the original portfolio is not affected because of heavy corporate redemptions.

Only if mutual funds actively discourage short-term investment in a fund that has long-term objectives will retail participation improve. SEBI should structure its measure accordingly.

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