June 12, 2018

Scheme Mergers Can Be Costlier Than You Think

As part of the scheme rationalization exercise directed by SEBI, HDFC MF merged its Balanced Fund with its Premier Multi-Cap Fund w.e.f. close of business hours on 1 June.  To put it more accurately, Premier Multi-Cap Fund, an equity fund, was first transformed into a hybrid fund and was renamed as HDFC Hybrid Equity Fund.  Then, on the same date, Balanced Fund was merged into that fund.  It was a complex manoeuvre that confounded many industry insiders and observers, including me.  

For one, at its heart, this was a merger of a hybrid fund with a pure equity fund.  Mergers between dissimilar funds are fraught with a variety of issues and are hard to justify.  Secondly, if, for some reason, such a merger was warranted, then the most practical and straightforward approach would have been to merge Premier Multi-Cap Fund into Balanced Fund (and not the other way round).  After all, the new scheme was more similar to Balanced Fund than to Premier Multi-Cap Fund.  Also, at the time of the announcement, Premier Multi-Cap Fund had AUM of ~300 crore while Balanced Fund had AUM of ~22,000 crore.  It would have made more sense for the smaller scheme to be merged with the bigger scheme than vice versa. 

Like many others, I decided to write it off as a mystery.  Then, last Friday, an investor in the direct plan of Hybrid Equity Fund reached out to me on this.  He had been an investor in Balanced Fund before the merger, and there was something that bothered him.  From what he could make out, after the merger, the expense ratio of his investments had significantly gone up.  He sought my view on whether this was actually the case.

It turned out that his observation was spot on.  Here are the facts:

  • On 1 June, the date of the merger, the total expense ratio (TER) of Balanced Fund (direct plan) was 0.56% while the TER of Premier Multi-Cap (direct plan) was 2.16%.   Post-merger, the TER of the direct plan of the merged fund (HDFC Hybrid Equity Fund) was 2.16%.
  • On 4 June, the TER of the direct plan of Hybrid Equity Fund was reduced  to 1.43%.  This continued till 7 June. 
  • From 8 June, the TER was reduced to 0.66%.

As would be evident from the above, even after the “reductions”, post-merger, investors in the direct plan of Balanced Fund (who opted for the merger) have been paying more than what they were paying earlier.

There is one other thing worth pointing out over here regarding the reductions.  It would seem that 0.15% of the reduction was on account of a change directed by SEBI to all fund houses.  In other words, if the merger had not happened, it was likely that, thanks to SEBI, the expense ratio of Balanced Fund would have been brought down to 0.41%.  If so, that makes the difference with the post-merger TERs even more glaring.

If my numbers are correct, in the 11 days since the merger, the investors in the direct plan of Balanced Fund (who opted for the merger) have been collectively charged (excluding GST) an additional ~67 lakhs (i.e. over and above what they would have been charged, had the merger not happened).  At present, by my estimate, they are being collectively charged (excluding GST) an additional ~2.3 lakhs per day (unless, of course, the fund house reduces the expense ratio further).

Something similar to this (though not to the same extent) happened to investors in the direct plan of HDFC Prudence Fund .  Like Balanced Fund, this, too, was questionably merged into an equity fund (HDFC Growth Fund) whose attributes were changed to make it a hybrid fund – HDFC Balanced Advantage Fund. 

All of this raises the question: did HDFC AMC act in an unfair manner with the investors in Balanced Fund and Prudence Fund, particularly those in the direct plans? 

Certainly, there are grounds to believe so.  Consider this: pre-merger, the AUM of Balanced Fund (direct plan) was ~3,500 crore while the AUM of Premier Multi-Cap (direct plan) was merely ~18 crore.  If their pre-merger expense ratios were to have been applied proportionate to their AUM, then the post-merger expense ratio should have right away been fixed at 0.57% (instead of 2.16%).

Of course, it can be argued that the merger letter to investors mentioned the then expense ratios of both schemes, so any investor who felt that he/ she was being treated unfairly, could have exited.  On the other hand, it can also be argued there was no mention of the possible increase in expense ratios in the key paragraph on “Consequences of Merger of Schemes” in the merger letter. 

It might be a good idea for SEBI to examine if something can be done to ensure that investors are treated fairly in mergers.

For now, this should serve as a cautionary tale for investors.

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