MFS must perform before the push for a performance-based fee structure

Mutual funds offer value to investors by way of efficient portfolio diversification and professional fund management. Hence the emphasis on mutual funds as the ideal way for retail investors to enter securities markets. The basic premise of mutual investing is diversification. The benefits of diversification were known, even before a mathematical formulation in the ‘modern portfolio theory’ of Harry Markowitz (1952). It is based on the old axiom of not keeping all eggs in one basket.

The other advantage of mutual fund investing is professional investment management. The assumption is that investors, especially retail ones may not have the time and/or required knowledge and resources to do their own research on companies and securities. A mutual fund is managed by full-time, professional fund managers who have expertise, experience and resources to actively buy, sell, and monitor investments. Hence the expectation that professional fund managers managing funds actively should perform better than the benchmarks or passive funds.

While mooting the idea of variable TER based on performance of schemes, the performance of actively managed equity schemes is presented in the Sebi consultation paper. As on February 2023, 58%, 67.28% and 73.34% of active equity schemes (regular) have underperformed the benchmark for 1 year, 3 years and 5 years. These performance matrices raise questions about the superiority of professional management of mutual funds as being claimed.

One of the explanations for the underperformance of many active equity funds is that they are not taking sufficient risks and are broadly following the underlying benchmarks and hence on post cost basis they underperform the benchmarks. Such funds are popularly referred as closet index funds. Given no superior performance, investors would be better off investing in low cost index funds than such closet ones. What needs to be understood is that to produce higher return than the benchmark, active risks are required to be taken which may come at the cost of diversification. A concentrated portfolio may have the potential of offering higher returns, albeit at higher risks. Such funds may compromise on the benefits of diversification. Of course, the regulations do ensure some minimum level of diversification across all funds. Another explanation of ‘underperformance’ is the doubts on the assumed superior skill set of fund managers.

There are a number of reasons why incentive fees are considered desirable. The oft-cited reason is that incentive fee aligns manager interest with investor interests. However, return-based performance fees may lead to managers increasing the risk exposures. There is a trade-off between the two presumed advantages offered by mutual funds—diversification and professional investment management. This trade-off between risk-minimisation and return maximisation at the granular level must be well understood by various stakeholders of the mutual fund industry. The major difficulty in attempting to evaluate the performance of the funds on these two dimensions—return and risk—has been lack of a thorough understanding of the nature and measurement of ‘risk’. Currently, in the risk-o-meter, all equity funds are high risk categories.

A simple solution of categorising various mutual fund products in terms of their primary benefit is useful. For example, index funds’ advantage is risk diversification and not to outperform benchmark return, whereas a sectoral or thematic funds’ main goal is return enhancement. A benefit-o-meter approach may be needed. Categorisation of equity products between diversifier and return enhancer will enable investors to make appropriate decisions. This has implications for performance measurement and evaluation. The journey towards ₹100 trillion AUM will be rewarding to investors, especially retail ones, if mutual fund products deliver what they claim, and demonstrate the claims to investors in clear and simple terms.

Dr CKG Nair is the director, and Dr Rachana Baid is professor at NISM.

Updated: 06 Jun 2023, 11:06 PM IST