The Hindu Business Line : MFs: Why not custom-tailor products?

There is an information overload in the mutual fund industry because of the multiplicity of products. These products are generic and do not help clients meet their investment objectives. The mutual fund industry should instead focus on custom-tailored products that help investors achieve their horizon objectives. Such products will require minimal investor education.

B. Venkatesh

In a mutual fund awards ceremony held recently, Dr C. Rangarajan, Chairman of the Economic Advisory Council to the Prime Minister, said that there was “indigestible information overload caused by the multiplicity of products in the mutual fund industry”.

The SEBI Web site, which showcases offer documents awaiting clearance by the capital market regulator, is a testimony to this deluge. You will find funds with generic names such as Long-term Equity Fund to those that propose to invest in the infrastructure sector.

Most of these funds have new names with same investment strategies as an existing family of funds.

The fund industry should instead construct investment vehicles that match the clients’ horizon objectives instead of launching generic funds. Such products will have fixed maturity and target specific investment objectives.

A 10-year Education Fund, for instance, will invest in assets that generate returns to finance the investors’ education costs 10 years hence. Such funds will better serve investors.

Importantly, the product will be easy to understand and will require minimal investor education.

Old wine, new bottle?

As with any other business, marketers of mutual funds need to understand customer psyche to peddle products.

Investors do not like buying units of existing funds at high NAV; they prefer buying units at Rs 10. Investors do not realise that it is the current market price of the assets in the portfolio that matters and not the actual NAV.

Suppose an existing fund invests in only one stock whose current market price is Rs 100. Assume that the fund has 100 units outstanding with total asset value of Rs 10,000. The NAV is then Rs 100 per unit. The unit-holder effectively owns one unit of the stock.

Now, suppose a new fund is launched that proposes to invest in the same stock at the same price of Rs 100 per share. Assuming that the fund sells 100 units at Rs 10 per unit, the unit-holder effectively owns only one-tenth of one stock! Essentially then, the current NAV reflects the market price — whether it is Rs 10 or Rs 100.

The strong preference for Rs 10 NAV prompts the mutual fund industry is one reason which continually introduce new products. With exposure to the same universe of stocks, one fund is hardly different from the other.

Custom-tailored products

What if the industry offers custom-tailored products?

Take a typical 30-year married couple with one child. Suppose their investment objective is to meet their child’s university-level education 20 years hence. They will have to invest in some generic fund such as India Opportunities Fund or Long-term Equity Growth and hope that their horizon objectives are met.

Fund-houses can instead tailor a 20-year Education Fund. Such a fund may invest in the same universe of stocks as that of the generic fund. The difference is that the portfolio manager will design an asset allocation policy that helps investors’ meet their future education costs.

There will also be good demand from investors who are currently excluded from medical insurance coverage. These are people in their late 40s who suffer from acute medical conditions.

A custom-tailored product will consist of a portfolio of stocks and bonds that will fold at age 65. So, if a fund is targeting 40-year olds, it will have a fixed-maturity of 25 years.

Of course, with a proliferation of such products, investors will require professional advice to choose from peer funds. But that is a far cry from the problem that they currently face- generic funds that have no specific horizon objectives.

Product structuring

Fund-houses currently offer fixed-maturity bond funds across the yield curve. Likewise, they can launch an education or health-care fund that has maturity ranging from five to 25 years or more.

There is, however, an important difference. Bond funds can easily horizon-match their objectives. The reason is that 10-year fixed-maturity plan will invest in a residual-maturity 10-year bond.

The fund will redeem the bond and return the proceeds to the investors. There is, hence, no price risk. This is the risk that a decline in asset prices at or near-maturity will prevent the fund from meeting its investment objectives.

That is not true of funds that have exposure to stocks. The reason is that stocks do not have finite life as bonds do. The fund will, hence, be exposed to price risk. Nevertheless, financial engineering can help fund-houses structure such products. Equity duration and portfolio immunization can help portfolio managers minimise the price risk at the horizon.

The mutual fund industry should probably focus its attention on such custom-tailored funds. Such a move will also force the investors to think about their long-term investment objectives. Will the industry take up the initiative to launch the generation-next products?

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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