Cheating small investors in Mutual Funds

This old article describes a way in which mutual fund distributors  and large investors collude to exploit small investors. Luckily SEBI has taken some measures to reduce this though.

“If the MF has spent 5% of the new fund raised towards the above expenses, effectively only Rs 95 of every Rs 100 will be available for investment. Rs 5 is treated as “asset” for the purpose of computing net asset value (NAV) and is amortized over a period of five years. In open-ended schemes, investors can enter and exit at will.

Such frequent transactions lead to transaction costs, the need to keep some funds in cash (an inefficient form) and liquidity risks or that of the availability of opportunities. But, a survey of entry/exit load structures indicates that, by and large, all funds tend not to charge either entry or exit loads on investments over Rs 5 crore.

Let us examine how this bias works. Suppose, a MF has collected Rs 100 crore and issued 10 crore units of Rs 10 each by spending Rs 5 crore towards marketing the issue. About Rs 30 crore is invested by four investors with an average investment of Rs 7.5 crore.

If there is no exit load, these four investors are free to exit any time at the prevailing NAV. If they exit in two days after the allotment without paying an exit load, the remaining unit holders will have to bear the expense towards marketing activities. The Rs 5 crore will be spread over Rs 70 crore instead of Rs 100 crore.

If any investor with an investment of under Rs 5 crore exits at the same time, s/he will be charged a proportionate cost of the marketing expenses or exit load. Besides, distributors who earn commissions of up to 4% of the funds raised often share this commission with large investors.

This practice induces “flight of investments” from one new fund to another as it is beneficial to both parties, even as the smaller investor suffers silently. The reform introduced by Sebi in the rationalisation guidelines simply puts a full stop to this practice.

They effectively force MFs to levy entry/exit loads on every investor that enters/exits a scheme or absorb the expense in to the fee charged by the MF scheme towards fund management. The new rules subtly introduce a cap on marketing and distribution expenses.

Funds that intend to charge higher entry/exit loads will not be able to garner subscriptions due to which they would like to keep them as low as competition permits. The ability of distributors to demand and extract higher commissions from fund houses will substantially diminish since a MF cannot pay more than the loads collected from investors.”

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Author: Bobbur Abhilash

I am a fourth year Doctoral student in the Finance and Control Department at IIM Calcutta.

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