The Hindu Business Line : Who pays for new fund expenses?

NEW fund offers raked in a whopping Rs 42,000 crore in 2005, becoming the key vehicles through which mutual funds soaked up investor money. Rising mop-ups under new fund offers have been accompanied by bigger promotional blitzkrieg to support the rollouts. Elaborate TV spots and front-page newspaper ads have replaced staid handbills as the key means of informing investors about a new fund offer. Nothing, really, is wrong with this.

If consumer goods companies can splurge on advertisements to sell soaps and skin creams, why shouldn't mutual funds do the same to sell a new fund? But the question is, who pays for the initial issue expenses and does every investor in a fund bear a fair share?

Who pays for issue expenses?

In most cases, it is the investors who stay with or enter the fund in its initial years, who pay for the issue expenses. SEBI regulations allow a fund house to spend up to 6 per cent of the amount collected during a new fund offer on initial issue expenses and charge this to fund.

Earlier, funds charged the entire initial issue expenses to the starting NAV, when the fund re-opened for subscription.

As the entire issue expenses were lopped off from the first NAV, a new fund would usually open below par (if the stock market hadn't risen sharply in the meantime).

But over the past couple of years, fund houses have moved to a practice where initial issue expenses are "amortised", or spread out equally over a five-year period.

This prevents a new fund's opening NAV from taking a knock, instead phasing out the impact of issue expenses on the NAV over its first five years.

Not equitable

Amortisation may ensure a healthy opening NAV. But it isn't an equitable way of sharing issue expenses between investors in a fund. When a fund charges the entire issue expenses at one go to its first NAV, investors who participated in a new fund offer bear the full costs associated with the launch.But when a fund amortises issue expenses, even investors who didn't participate in the initial offer but entered it later, within the first five years, get saddled with a portion of initial issue expenses.

More important, investors who participate in a new fund offer for short-term gains actually benefit from this treatment. They bear only a fraction of the issue expenses, if they exit the fund within the first six months or a year.

Fund houses are beginning to correct this anomaly by imposing exit loads on pullouts from a new fund within the first six months or a year. But the penalty needs to be stiffer and imposed without any exemptions to larger investors.

Old versus new funds

Then, there is also the difference between the expenses allowed to older funds and new fund offers. Regulations allow new funds to spend up to 6 per cent of the assets collected towards promotional and launch expenses. But existing funds that are available on tap have to restrict their annual recurring expenses, including the fund manager's fee, to 2.5 per cent of their assets.

What is more, while new fund offers, irrespective of size, are allowed to spend 6 per cent of their assets on issue expenses, recurring expenses on established funds are subject to a slab-based system. In established funds, larger funds are allowed to spend only a smaller percentage of their assets towards expenses.

The cap on recurring expenses declines with each Rs 100 crore addition to the asset size. If the slab-based system has been put in place to make sure that economies of scale are passed on to investors, then the same yardstick ought to be applied to new funds as well.

When it comes to the expense structure, such differences between established open-end funds and new fund offers do not appear justified. Unlike stocks, with mutual funds, even existing funds have to market themselves to investors on an ongoing basis to grow their corpus. Therefore, marketing or distribution initiatives are not a one-shot exercise restricted to the offer period, as is the case with an IPO from a company.

The liberal expense limit on new fund offers is partly responsible for the slew of new launches, the sheer multiplicity of products on offer and the investor fancy for new fund offers "at par".

Yet, experience over the past ten years suggests that the interests of fund investors may be best served by entrusting money to established funds with a good five-year or ten-year track record.

There appears to be a strong case for treating established open-end funds on the same footing as new fund offers, and subjecting both to a slab-based system, when it comes to expenses.

This may help nudge investors towards the mutual fund products, whether old or new, that best suit their investment objectives.

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