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Suresh Krishnamurthy

Costs charged to income schemes show no sign of declining. Their high levels take away from the attractiveness of mutual fund income schemes. If the issue is allowed to fester, it could harm the growth of debt schemes.

THIS is probably the wrong year to look at the issue of costs charged by asset management companies to diversified income schemes. In the backdrop of a decline in prices of debt securities, the costs charged to schemes would strike investors as abnormally high. And it seems irrational for the AMCs not to have worked out a suitable solution for investors.

This is probably the best time to ram home a solution that favours long-term interests. Such solutions exist and a crisis, like that which has engulfed income schemes now, offers a unique opportunity for all parties to offer concessions and strike a deal that enables the industry's growth.

The issue is, however, being allowed to fester. Instead of working out a direct solution, investors are being shepherded into floating rate schemes and short-term income schemes, where the costs are lower. It is not clear if this is a workable solution. It is also not clear if floating rate schemes are suitable for investors over the long term.

Costs lower returns: Almost all diversified income schemes have posted negative returns during the half-year ended September 2004. The costs charged to the schemes have not changed at all. Costs have stayed high — in some cases, unconscionably so, at above 2 per cent.

Over a year ago, when the issue of costs eating into returns was raised, many Chief Executive Officers of AMCs indicated that when returns decline, costs would automatically decline and that competition would ensure that they do.

Unfortunately, that has not happened. Despite the presence of five or six large income funds and about 20 income fund managers there is no indication of competition for retail funds.

What has happened, instead, is that costs have increased in a few cases. This is because the AMCs have had to contend with sharp fund outflows. A decline in the funds under management does not allow any scope for reducing costs. In the event, performance has suffered. The performance of floating rate schemes and short-term income schemes has, in contrast been better.

The superior performance of these schemes in this half-year owes as much to lower costs as to friendly market trends. In most cases, short-term income schemes and floating rate schemes charge costs that are half of what is charged to diversified income schemes. Indirectly, there is thus a pressure on investors to shift to floating rate and short-term schemes. Inflows into floating rate schemes have risen quite sharply consequently.

This, however, may not be in the interest of investors if interest rates stay stable. If investors forget to shift to long-term bond funds at the right time they could lose heavily.

In addition, it is surprising that the management of diversified income schemes has been carried out in such a way that they have lost money. Diversified income fund managers have a mandate for active management. What stopped these managers from shifting to treasury bills, floating rate instruments and short-term corporate securities to ward off erosion in value is not clear. On the whole, the fund management industry appears to have plumped for a short-term patch that is sub-optimal for investors.

The solution: A practical solution to this mess would be to ask brokers to charge fees directly instead of receiving compensation from schemes.

If an investor goes directly to the asset management company he would not have to pay costs. If an investor goes to a broker and wants his services, the latter will charge fees. This is the only workable solution.

There is apprehension that Indian mutual fund investors are not mature enough to appreciate paying for financial advice. The fund industry does not, however, have any option. As long as costs stay high and small savings offers attractive returns, investors would prefer direct investing to mutual fund investing. There is also the danger that insurance companies will be preferred ahead of income schemes.

It would also be easy to work out a transparent alternative when the industry is small. Ten years down the line, a solution may be beyond any of the industry participants.

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