Zero Exit Load…A boon for speculators

Jayant Pai | jayant@ppfas.com

I saw an advertisement on the Value Research website last week. It showed a family exulting in the fact that their child had secured “Zero” marks in the examination. The father was holding a placard stating that “Zero is the new Hero” and the mother was doing a jig. The ad screamed “Zero exit load on two of our flagship funds”.

The ad could be considered hilarious, if it were not so depressing. What is the mutual fund trying to communicate? Equity mutual fund managers espouse the cause of long-term investing and the virtues of “time in the market rather than timing the market”. Is such a development in sync with this belief? It will only encourage hot money to enter and exit at zero impact cost. It will also prevent the fund manager from taking a long-term view w.r.t. investments. For instance, in the normal course, a fund manager could have allocated 20-25% of the corpus to promising mid-cap and small-cap stocks which were relatively illiquid. That will now be virtually impossible as the sword of untimely redemptions will always be hanging over his/her head. Consequently the manager will play safe either by keeping aside large amounts of cash or investing in liquid stocks even if they are not the best choices at that moment in time.

This appears to be a clear case of the fund’s sales team triumphing over the investment team. Such moves to boost assets will be counter-productive in the longer term. Once a fund house becomes notorious as a channel for “hot money”, investors with a longer-term outlook shy away from it, as it is well known that sharp ebbs and flows in assets in any scheme hurts the longer term investor more. When SEBI jettisoned the entry-load concept, most of the major fund houses increased the exit load. More than earning income, the objective was to discourage quick entry and exit. Unfortunately, the battle for survival amongst the smaller funds has induced them to opt for this “100% Free” route.

I hope this does not lead to a competitive free-for-all (no pun intended) amongst such funds, who will be competing against one another on price and not on investment performance. This will be detrimental for the whole industry and this time they will not be able to blame the Regulator for the same….

The watchdog can also bite

Many a times, one becomes cynical about the ways of justice and rule of law in India. Instances like the delayed process of law in the Bhopal Gas Tragedy lead one to question whether the rules and regulations really matter.

In such an environment it is heartening to see the painstaking investigation and action by SEBI in the matter of front running by a Mutual Fund dealer. Victims in fraud cases and in ponzi schemes are easy to identify and they are the ones who demand justice. On the other hand front running and insider trading are seen as what is called “victim less crimes”. It is difficult to precisely identify the victims of such crimes. The victims in such cases may not even be aware that they have been defrauded.

The current case was especially difficult to investigate as the front entities indulging in the trades had no apparent connection with the Mutual Fund in question. It must have been a difficult task indeed to have identified the connections and then to have confronted the individuals with the evidence. Cases of insider trading and front running have been difficult to prosecute in other countries as well. In the face of such odds SEBI seems to have done well in getting sworn admission of guilt from the accused in this matter.

Suspension of such individuals from the market and recovery of the ill gotten gains is only the start. One would want to see criminal prosecutions in such matters.

The is a warning to all those who indulge in insider trading, front running and market manipulation. The watchdog can also bite.

Hedge funds, RBI, SEBI, FMC and financial pariahs

There has been some noise lately about regulating hedge funds in the developed markets. Most hedge funds are structured as Limited Liability Partnerships (LLPs). People say that oversight of the central bank (Federal Reserve) and the securities regulator (SEC) is required as some of these hedge funds can cause “systemic risks”. 

By “systemic risks” I presume we are talking about

a) Banks and other institutions (like insurance companies) which raise money from retail depositors suffering losses, or

b) The securities market having large disruptions on account of the large volumes controlled by these hedge funds.

In India these issues have not arisen yet. We have recently passed an act allowing formation of limited liability partnership firms. It is possibly a few months before we start to see the formation of LLPs in India on account of registration and taxation issues.

Just because a few “enterprising” ex-fund managers / investment bankers get a few rich individuals to partner with them in a LLP Hedge Fund to play the markets does not mean that these will become systemic risks to the banking system in India. 

The necessary condition for sytemic risks is the lending of money by banks and financial institutions to these entities for making leveraged bets. In India, hedge funds (or individuals for that matter) have severe restrictions in accessing bank funds (against securities as collateral) or in accessing OTC foreign exchange derivative markets (run by banks) or accessing the repo market. In fact, any entity which is not a bank has very limited access to any market governed by RBI. Anybody having anything to do with the stock markets is a financial pariah for RBI. I do not think RBI will have too much problem with LLPs coming in.

My feeling is that SEBI and Forwards Markets Commission (FMC) however will have a tough time. In the race to increase volumes and profitability, stock exchanges have included all sorts of stocks in the Futures and Options segment of the equity markets. Margins are adequate on most days in a year but are found short on days of high volatility. “Black Swan” events are not considered and “Six Sigma” events occur pretty regularly . Currency futures are here and so are commodity futures. FMC currently prohibits “portfolio management” kind of services in the commodities segment. A LLP however would be dealing on its own account and hence technically would not be managing trades for anybody.

Hedge funds starved for funds from banking sources could go amok in the exchange traded markets on the derivatives side. Mutual Funds and Portfolio Managers have strict guidelines on what they can do and cannot do in derivatives. Leverage is prohibited. Hedge Funds would not have such restrictions.

What should be done is that unreasonable restrictions on market access (especially from RBI’s side) should be removed on portfolio managers and mutual funds and hedge funds should bear some restrictions in exchange traded markets. 

Do Mr. D. Subbarao, Mr. C.B. Bhave and Mr. B. C. Khatua need to look at this?