December 01, 2014

Simple and Performing Schemes

In 2012, SEBI lay the foundation for, what it hoped would be, a vast increase in the number of mutual fund distributors by allowing a simplified certification process for anyone who met one of several criteria.  The caveat was that these distributors would only be allowed to advise on, what it would define as, ‘simple and performing’ schemes.  This was one of a series of measures intended to, in SEBI’s words, ‘re-energize the mutual fund industry.’  With the passage of time, I gather from conversations with industry insiders that this has turned out to be one of the less-appreciated of those measures.  For me, on the other hand, it was the idea of having a set of schemes that are simple to advise on, and likely to perform, that I found most interesting.  In it I saw, and still see, the potential to open the floodgates to mass adoption of mutual funds.

Mutual fund schemes are not the most preferred investment option for most Indians.  In my analysis, this is because investors are not sure what to expect.  There are no assurances of returns, and there is little predictability. While it is true that most Indians' decisions regarding where to invest (other than deposits with a bank or a government entity such as the Post Office) are influenced more by their advisors' recommendations, and less by the merits of the entities with whom the investments are being made, most advisors themselves lack conviction.  This, I believe, is no small measure due to the complex nature of mutual funds and the absence of simple products that could be tried and tested before being trusted.  It is only in the last few years, through the relentless push on FMPs that this void has begun to be filled.  It is no surprise, therefore, that FMPs are a part of the categories of funds that SEBI has deemed to be simple to advise on.  It is, though, inexplicable as to why SEBI has also included diversified equity funds and index funds to that list.

As I see it, ‘simple’ schemes should be of the kind that one can invest into (with a reasonable time frame), and afford to forget about until it is time to exit.  If one chooses to look up their performance midway, these shouldn’t give reasons to be overly worried.  Equity funds, be these diversified or passively managed, call for far too much risk management to fit this definition.  Even if one were to restrict the choices to funds that meet SEBI’s performance parameters (“should have returns equal to or better than their scheme benchmark returns during each of the last three years”), there is still the possibility of significant, unpleasant surprises.  In 2008, for instance, all the diversified equity funds that would have met SEBI’s criteria, fell between 43% and 66%.  In fact, the fund that fell the most, had actually beaten its benchmark each year from 2002 to 2007 and was the only fund with top quartile returns (when you consider all diversified equity funds) in each year from 2004 to 2007.  That fund’s performance in 2008 more than wiped out the gains of the two preceding years.

In my view, other than FMPs, the fund category that most easily qualifies on grounds of simplicity is that of liquid funds.  The next best category to include would be what are increasingly referred to as, ‘accrual debt funds.’  This is not a category that is easy to define and monitor. In the absence of anything better, I would include debt funds that have consistently had an average maturity of 3 years or less.

The above categories give a distributor enough options to offer good choices to anyone with an investment time horizon of up to 3 years.  For someone with an investment time horizon exceeding 3 years, one would need to look beyond these categories.  This is where things get difficult. None of the categories that would be suitable for such a time horizon can actually be considered simple to advise on.  Relatively, the most simple categories to advise on, would be a.Debt Funds with marginal equity exposure and b.Tactical Asset Allocation Funds.  Even so, schemes in each of these categories need to be carefully examined before selection.  In other words, the way out is to include specific schemes, rather than categories.

I recognize that the selective inclusion of some schemes may not represent a conventional approach.  Some may even regard it as controversial.  There may also be a limited choice of schemes.  In the category of Tactical Asset Allocation Funds, for instance, I can think of only one scheme worthy of inclusion.  Nevertheless, I believe that if we are to build a list of such schemes for those people with investment horizons of over 3 years, this is the best way to do so.

I believe that the concept of having a shortlist of funds that are perceived as simple to advise on, and reasonably predictable as to their performance, is ground-breaking.  It can reduce the complexity of investing in mutual funds to a level that isn’t very different from what one would associate with bonds or company deposits.  Just as envisaged by SEBI, it can reduce the need for having skilled advisors to reach the masses, making mutual fund schemes accessible to them.  We simply need to get that list of schemes right.

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