Closed-end funds protect investors

The biggest story in the Indian mutual funds industry in 2014 has been the launch of a multitude of closed-end funds. One of the epicentres of the trend was at Sundaram Asset Management Co. Ltd. The fund house has launched 15 such schemes (the most by any fund house). Many closed-end funds launched this year have also been paying high upfront commissions to distributors; something the capital market regulator has taken note of. But are closed-end funds bad? In an interview with Mint, Sundaram AMC’s chief executive officer, Harsha Viji, says that closed-end funds can deliver where open-ended funds have failed.

In the past year-and-a-half, why has Sundaram AMC launched so many closed-end funds?

If you ask any MF as to what’s the right way to invest, they’ll tell you to have a three-year time horizon, look at systematic investment plans (SIPs) and so on. That’s not working. Why? Because the past 6-7 years have been a disaster in terms of the market, and in terms of what investors have seen. Fifty per cent of investors who had invested in the past 4-5 years have not had a positive experience. They went out at a lower net asset value (NAV) than what it was when they came in.

Numbers may look attractive on paper, but investors have not tasted returns. Retail investors say that they are coming in with a three-five-year outlook. But on an average, they stay for two years, maximum. Everyone comes with a 5-year SIP. But they stop within one-and-a-half or two years. So, retail investors are shooting themselves in the foot, mistiming the market, getting poor returns and then telling all their friends to never invest in MFs. The problem is investor behaviour; no one wants to stick around for the long run. At the same time, fixed deposits are easily available and give assured returns. So, one of the things that we’re trying as an AMC is closed-end funds, which seem to be getting a bad name in the industry and that is very unfortunate.

Closed-end funds are not for everyone. Actually, most inflows are not going into closed-end funds. A big deal is made out of that. Only some 5-7% of inflows are going into closed-end funds. In reality, a closed-end fund stops you from harming yourself. A 3-year closed-end fund is also on the edge, I’d say, but if you put your money in a 5-year closed-end fund, statistics of the past 30 years will tell you that you will make money. Because investors won’t panic and pull out; they cannot. And the fund manager can comfortably take a long-term view, as investors will stay put.

Clearly, the distributor gets a piece of the pie. And ultimately, as an AMC, if I sell only closed-end funds, I will have lesser sales than those that sell open-ended funds. But I will be confident that at the end of five years, my investors will leave saying that I got better returns from Sundaram AMC.

What if the markets are down on the day of redemption? That’s not something you can guarantee, right?

That’s the biggest fallacy. In an open-ended fund, too, you can choose a day to redeem. Will you make money? Not necessarily. Fifty per cent of the times, you won’t. In open-ended schemes, people have an illusion of control. Investors consistently mis-time the market. Even during the 2008 crisis, retail investors continually mistimed. What if on that day the market drops? Well, what if it peaks?

But in closed-end funds, the investor has to take her money back compulsorily on redemption day. She can’t stay invested and wait out till the volatility goes away.

She can switch to some other fund. She needn’t take the money back. She can keep it invested in the equity market. The concern is not that investors can’t get their money back, but that they can’t pull it out early.

If the equity market were in a correction mode, your closed-end funds’ NAV would have still dropped.

Correct, but look at the track record. Assume you had invested in the Sensex for any one-year period since inception till date; you’d have lost money about 35-40% of the times. If you had stayed for any five-year period, there’s a 5% chance that you’d have lost money. If you had stayed invested for any 8-year period in the market, there’s a zero chance of losing money. Investors, however, don’t believe this.

The fact is that equity is not a three-year asset class. Those who want liquidity should never invest in a closed-end fund. But if liquidity is not a problem, I am almost guaranteeing they’ll have a positive experience from the MF industry. The odds of losing money keep reducing as the holding period increases.

Closed-end funds aren’t really being sold on merit. Distributor commissions on these products are very high.

There’s a lot of unnecessary commotion on that subject. If it’s a 5-year closed-end fund, and the AMC is taking it on the balance sheet, and basically funding the distributor by giving it an advanced commission, does it hurt anyone?

It could hurt if it leads to mis-selling. Many of the fraud cases have happened in open-ended funds, in the new fund offers (NFOs). You need to have a mechanism to catch mis-selling. That’s doable. Punish the AMC and the distributor involved. If we penalize three such people, all the others will fall in line.

Mis-selling must be stamped out. To do this by banning upfront commissions or putting restrictions may be well intentioned but is not going to achieve anything. If you put a cap on pricing, people will find a way around it.

The problem in high upfront commissions is that it sets a bad precedent. Some distributors, like banks, could twist the arms of other fund houses.

We are worrying about a large theoretical problem. Just look at the reality—everyone is launching closed-end funds; everyone is paying high commission. What percentage of sales are closed-end funds? India’s big AMCs are launching (closed-end funds), but with all that, (sales of these funds) is only 10%. That’s because investors don’t want to put their money and not have access to it for 3-4 years. So, closed-end funds, by their very nature, appeal to a certain set of investors. It’s not spoiling the market in any way.

Perhaps, but open-ended funds are also being forced to hike their entry loads and increase upfront commissions.

Nobody is being forced to do anything. All that is pricing. If a large AMC complains that the small guys are giving discounts, then it has to deal with it and move on. It’s business.

There is no cause to single out closed-end funds. Are all open-ended funds sold purely on merit? If distributors are selling closed-end funds purely on commission, why is 94% of inflow coming only from open-ended funds?

Inflows from closed-end funds as a percentage to overall inflows was perhaps just 1% earlier, but now it’s about 10%.

No, when we used to use just capital-protection funds, it was still a good part of the market. Somewhere between 5% and 10% (of the total inflows) have always been NFO-driven. And if only high commissions drove closed-end funds, the inflows would have been much more.

Even in the IFA (independent financial adviser) space, closed-end funds are a minority of the overall sales. So, getting customers’ money for five years is a tough job for a distributor. The time and effort needed to sell closed-end funds is much more than that required to sell open-ended funds. So, the distributor needs more compensation, which is why we give it.

If that compensation was so high that they could make tonnes of money, they would be selling five times as much. We make a big deal of a closed fund NFO that garners, say, 500 crore. But at the same time, quietly, 3,000 crore is coming in open-ended funds. No one talks about that. Closed-end funds level the playing field.

How is that?

To get an open-ended fund off the ground, you need to get separate approvals, push through distribution, each bank will approve, say, only five funds; one of those would most likely be from top five AMCs, and so on. The remaining firms have a small slot to fight for.

But with a closed-end fund, the NFO space is much more democratic. The possibility of an MF getting approval, launching an open-ended fund and getting traction is virtually zero, given the competition and the qualification requirements of distributors, like one, three, five years’ track record and so on. In closed-funds, manufacturers sell a idea based on a strategy.

So, are closed-end funds also a strategy for smaller and medium sized fund houses like Sundaram AMC to compete with the bigger fund houses?

India’s big—or, so to say, most of the top 10—Indian AMCs are launching closed-end funds. It’s not a small fund house strategy.

Launching closed-end funds in succession enables fund houses to charge a higher expense ratio of 2.5% (for each scheme launched) on account of being small-sized. Isn’t it better for investors to have one large fund (and charge lower expenses, as per regulatory formula) instead?

It depends on a scheme’s objective. For example, a lot of our launches have been small- and smaller-cap (micro-cap) schemes. Keeping it closed-ended has logic because fund managers can’t manage with dramatic inflows and outflows of cash. Since November 2013, we have launched seven micro-cap funds and one small-cap fund. Such funds need to be closed-ended.

It’s widely known that the market regulator doesn’t give clearances to NFOs easily, especially when funds look similar. Have you faced any trouble getting approvals for closed-end funds?

The first time we put the series up for approval, we needed to explain a lot. When we had filed our micro-cap offer document for the first time, we had asked for a small percentage of money to be invested in small-caps. But Sebi (Securities and Exchange Board of India) didn’t allow us to do that, since we were already investing in small-cap companies through an existing scheme. So, we dropped the plan to invest in small-cap companies in our micro-cap series. That type of dialogue happens very openly.

Once we get approval for the series, we can launch funds. It’s not that the idea of micro-cap is valid only today. It’s valid tomorrow also; and the next month and so on. We want to have on-tap ability for investors to enter. But I can’t make it open-ended because even if 10% of my corpus withdraws, I can’t sell these shares in a hurry. These are very illiquid shares. That’s why they are closed-end funds.

Given that micro-cap companies suffer from illiquidity, how will you manage your schemes’ liquidity as they near redemption dates?

When we get the money, we’ll invest money over a period of six months. When we near redemption, we’ll also start divesting money over six months. We’ll slowly start to sell our underlying shares as we approach the redemption date and we’ll increase cash, so that we’re completely liquid at the end.

Suppose the markets keep rising as you near redemption; you’d be selling and limiting the upside.

But that’s the price of liquidity. I have to liquidate the portfolio on the redemption date.

Sundaram AMC has been single for a long time. Earlier, you were in a joint venture with Newton, then BNP Paribas. Any aspirations to go for a joint venture or bringing an international partner?

It can definitely make sense. But such a joint venture should bring value on the table in terms of capability or distribution or international funds (the money that they collect internationally) that can be managed out of the Indian AMC.

In terms of distribution, I wonder what they can add because we are firmly entrenched into our distribution system here; we’re settled in that quarter. In terms of knowhow and capabilities when BNP Paribas came, it helped us a lot. But now we are at a stage where there is no gap, though I am sure we can use help from the right partner. If someone can bring in money into the business, that’s definitely something to look at. But we’re not looking for a financial investor and we’re not looking for an exit.

That brings me to my next question. Word on the street is that since you are from the Sundaram family, you are building up the business to a sizeable scale and quality so that you can find a good price to sell out. True or false?

The other way to put it is we’re growing the AMC. If I was building up for a sale, I would be burning profits and Sundaram AMC would be twice its size. We’re running the business as operators. We are not in this for a quick buck. Unlike many other start-up AMCs, we didn’t burn capital. We started in 1996 and now we are in 2014. In no single year did we make a loss. Not that we’ve made huge profits, but we aren’t in loss either. We have never pressurized our fund managers with if they don’t perform, we’ll shut down in a year’s time.

We’re open to a partnership, provided there’s value-add.