Wring out the old - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Wring out the old A  A  A
3 JANUARY 2008

For decades, I dreamt of starting a mutual fund in India.

In fact, my first job on my return to India in 1984 was with the late, Mr. Ashok Birla - a visionary who was more global than all the Indian industrialists combined.

Although Mr. Birla was a member of the Birla group and an obvious beneficiary of the license raj, he was always tossing ideas to the powerful bureaucrats about removing the restrictions that gave consumers less choice. Rules that made Indian industry fatter and richer - at the cost of the consumer.

One of the ideas that Mr. Birla tossed up was the launch of a mutual fund which would raise money from non resident Indians and foreign investors and then invest in this corpus in the Indian stock markets. That venture was proposed in October, 1993.

At that time UTI was the monopoly manufacturer of mutual funds. The fund managers were really the politicians and bureaucrats in New Delhi who told UTI what to do. It was part of the loop, you see: the industrial license raj, the bad choices for consumers, and then the allocation of scarce capital to the favoured industrial groups. It was the kind of deal that made a few rich at the cost of many. It was the result of this arrangement that effectively saw UTI lose billions for its million of investors.

But, because of powerful lobbying by UTI and a mis-informed government, Mr. Birla never got his approvals to launch India's first overseas mutual fund. That privilege went to UTI followed by approvals to sister government-controlled entities like State Bank of India and Canara Bank.

In 1990, I set up Quantum and in 2004 applied for an approval to set up an Asset Management Company (AMC) to launch mutual funds. The eligibility criteria for an AMC license are based on qualitative and quantitative criteria.

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Qualitatively, one had to be a fit and proper person. I was deemed good enough to manage money on a global platform. To head the global investments team of a US-based investment management company with Rs. 20,000 crore under management. My partners and I were "fit and proper" to manage money for respected pensions and long term investors.

But the Indian AMC license had eluded us for years because we had failed the quantitative criteria: we did not have the minimum net worth required to manage other people's money. Kind of a silly rule, really. An investment manager is like a doctor or an auditor or a lawyer. We need a basic office to provide our service - the service of selecting stocks or bonds for your portfolio. We never take those stocks with us home every night. Nor do we take your cash home every night. These shares and cash balances are in the accounts of the mutual funds and, ultimately, these assets belong to the unit holders. So why this minimum net worth criteria?

Do you ask your doctor how rich he is before you bare your body in front of him? Or do you ask your auditor what his net worth is before you invite him to audit your accounts? A normal person would just wish to know how good that doctor, auditor, and lawyer is and whether he has the experience to look after you. I have never understood the need for a minimum capital requirement for a fund manager. But that's me - I don't seem to see the light of day even when everyone tells me it is a bright sunny day outside.

I remember the excitement and sense of fulfilment when we got the license to be set up an Asset Management Company. All those years of theory, all those years of wanting to manage the savings of the retail investors in India…. But getting the approvals was not the end of our journey. In many ways, it was the beginning.

Because we were struck by reality.
The reality of transforming an idealistic venture into an on-the-ground business.

When we got our license, we went about meeting members of the distribution channel to see how we could best position our investment philosophy and our investment approach. We had been so engrossed in managing money for our international clients that we really had not spent much time on figuring out how to gather those assets in the Indian environment.

Within a few meetings it was apparent: the large distributors were the gatekeepers.

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They controlled asset flows - and the assets were given to those mutual funds that paid the most commissions. The servicing channels were not necessarily servicing their clients but probably servicing themselves.

Imagine. You do good deeds your entire life. You end up at St. Peter's gate, the doorway to heaven.
And St. Peter asks you how much you are willing to pay him to get through.
It does not matter whether you have been good or bad - whether you are suited for heaven or not.
Pay the money and you get all the riches.
Heaven is what your money can buy.
A successful fund is one which pays the distributor the most, not the one that is best suited for an investor.

Pay us, said the distributors - in our discussions with them - and we will get you the assets. And how much assets we gather for you depends on what you pay us. This is how we treat all the other AMC entities - this is how we treat everyone.

Not wishing to deny anyone a fair livelihood, we heard what "everyone" in the industry does. What the other mutual funds did. There are free tickets for overseas holidays. Free cars. Free suits and clothes. Sure, there are rules about what one can and cannot do. But, said the powerful distributors, we are the ones that really rule. The consumer may be king - but he will only see those who we let in the gate.

At one of the meetings, we tested the idea. What if we do not pay you a high commission but paid you a low commission, then what would happen? "No interest", they responded.

We pushed the envelope further. What if we did not pay distributors any money and had no front end loads? "Ha, ha", they laughed, "we have made the elephants dance to our tune, and you are an ant!"

And they were right.
There were 31 AMC entities before us.
Global names, local names.
Global vision, local expertise.
Global expertise, local knowledge.
Locally powerful groups, globally powerful groups.
Industrial giants, global financial giants.
They really were elephants. And we were the ant.

The distributors were right. They had achieved quite a feat. Look at the list of the giants in the industry.
They really had made all these elephants dance. And all these elephants were dancing - willingly or not, but they were all part of the system. Why? We can only hazard a guess. Because they were running a business. An asset gathering business.

Asset gatherers, like most male animals, strut around telling everyone how large they are. "Wait a minute", we thought to ourselves, "we just got an AMC license - an asset management license, not an asset gathering license."
Why should an investor care how large you are?
Investors want a return on their money. Investors want to see that the mutual funds they invest in do what they are supposed to do - invest money in a particular way that gives investors the long term exposure to that specific asset class.
How large a fund house is has no relevance to the act of investing money. If the size of a fund house was an important criterion for being good at managing money then all the large fund houses would have all their funds always ranked in the top. But the records don't show that.

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The Indian mutual fund industry seemed like a business being run for the benefit of the asset gatherers and the folks who control them in the distribution industry. The investor's interests were, well, left at the gate.

So we took the stand.
And we drew the line.
And we crossed over: We are on the side of the investors.

There is a role for distributors and for financial planners. And everyone must make money.
We recognise the need for "business" and we understand the "profit motive".
I did study economics and graduated from business school.
But, the problem is, my favourite course was "ethics in business".
Professor Jack Behrman kept on discussing case after case where the basic theme was: Can you make money without cheating someone?

Infosys has done it.
HDFC has done it.

Quantum can do it.

So, in March 2006 we launched the Quantum Long Term Equity Fund followed by the Quantum Liquid Fund in April 2006.

Both the funds are "no-load" funds with no entry loads.
And no commissions for distributors.

In March 2006, at a press conference to announce our launch, I was asked, "what is our strategy or, are we going out there on a prayer and a hope?"
Yes, I replied, we do have a strategy. To launch products which make sense for the investor. Performance, we said, will chart our growth. If we perform, we will get the money. If we do not perform, we do not deserve the money.

We will not buy assets. That is a game in which the investor is the loser.

Take a look at some statistics. The month that we launched, there were some pretty large equity funds out there. One of them, for example, had assets in their flagship fund of more than Rs. 3,100 crore. Since then, the NAV of that fund has risen by some 90%. The fund has done well. If indeed the distributors had cared for their clients, they would have let the money stay in this fund. And if all the investors had stayed in that fund, the fund should have had assets of some 5,900 crore by now. Yet, the fund has assets of "only" 3,800 crore. This is a 20% increase, not the 90% increase that should reflect the growth in the NAV if all investors had stayed put. Where did the Rs. 2,100 crore disappear? This fund did not perform badly so did it deserve to see all that money go out the door?

Why is there this difference? Because, like other fund houses, assets have been bought from the distribution channel. Those assets did not stay. They were "sold" to this fund house and then "re-sold" to the next asset gathering body willing to pay more. The investors have been churned in and out of so many funds, it makes a mockery of the business of fund management. It shows that distribution channels have generally not been on the side of the investors.

The press has written a lot about the power of the distribution system. The regulator, SEBI, has shown concern. In August 2007, SEBI made the proposal: any investor who deals directly with an AMC need not pay any commission to the distributor. This is now a law.

We say, "Welcome to the world of Quantum."
And may more fund houses sign up and cross the line. Move over to the side of the investors. Like we chose to do. For two years we have fought a solo battle. We have preached and practiced what is now the law. We are grateful that the regulations support what we have been practicing. We are grateful to the press for writing about the problems the investors have faced and helping the investors take a stand.

The SEBI law is a first step. There are still many problems with this system. For example, to invest online in the Quantum Long Term Equity Fund, you need to send us your PAN card. So, there is a physical break in the online process. Once we verify that the PAN card is okay, then we send you back a confirmation that you can start the online application process again. A process that can take a few days. A process that has a time break to it. A process that encourages the investor to head back to the physical distribution system where verification of the PAN card is instantaneous.

Maybe SEBI needs to modify the online investment process to say that investors can apply online and they will be granted the units of the fund on the day they apply but, if the PAN card is not received by the fund house in 10 days, the units are forcibly redeemed and a 5% exit load is deducted from the proceeds which are remitted back to the account of the investor. This would encourage investors to use the online systems and reduce the costs of investing.

Looking forward, the best fix would be to ban all commissions to distributors of all financial products.
Let the fees come from the investors.
Whether for home loans, insurance products, or mutual funds.

When you go to a lawyer or auditor, they give you a bill for their services. You can then decide if the service you got was worth the money you paid for.
If it was, you go back to the same lawyer or auditor.
If not, you find another lawyer.

And no kickbacks and rebates to any distributor from any manufacturer. If any manufacturer is caught giving a kickback to any distributor, they lose their license to practice. Like a doctor who may be caught pushing a specific pharmaceutical company's product (because he is offered an extra kickback) loses his license.

SEBI has said that fund managers are service providers like doctors and need to pass exams. Doctors pass exams, too, and have certain ethical norms to follow. The fine for breaking the law is a loss of the medical license. Let's adopt that in the mutual fund industry.

The present system has had too many hidden costs that, eventually, have been paid for by the investor. SEBI needs to wring out and flush out all these malpractices. And ring in the new system of transparency and fairness. For 15 years the India mutual fund industry has treaded questionable practices.

There are many distributors and financial planners that wish to make a decent and honest living. Who are repulsed by the practices indulged by many fund houses and distributors. The SEBI gift to investors is also a ray of hope to these ethical people that there is a straight forward way to make money.

I hope that the year 2008 will be that turning point when SEBI wrings out the old, and bring in the new.

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