Fund prospectuses: Too much legalese, too little substance  

March 11, 2010

Mutual fund prospectuses are fat documents that can turn off even the most intrepid investor. There are pages and pages of legally mandated disclosures but they have absolutely no truck with what the investors really need to make an informed decision. Stripped off their legal content, these documents are essentially a few pages of paper filled with bland information of little substance.

Whether a fund wants to invest in mid-cap stocks or Brazilian stocks or infrastructure stocks, the quality of disclosure is the same. Disclosures on what has gone into the portfolio design are non-existent. Explanations as to what distinguishes the stock-selection process of the fund managers are non-existent. Even the disclosures that appear don’t reveal the full facts.

Recently, HSBC Mutual Fund has filed a prospectus to launch a fund of funds that would invest in Brazilian stocks. This is an exotic fund. Who has ever heard of a name like Companhia Vale do Rio Doce (CVRD), one of the world’s largest producers of iron ore? If HSBC wants to pick your money to invest in CVRD, the least it should do is have a long section devoted to explaining the structure of the Brazilian economy, its corporate sector, how these companies and their stocks have performed in different market cycles, what are their current prospects, the level of governance, the likely political change after the coming elections and so on. And finally, investors need to know whether HSBC has any experience in navigating this market with multiple products over different cycles. Even then, one would like to know who is managing the money for HSBC, whether he is a local or not and how long this fund manager has been around doing this same job. Or, will HSBC’s giant asset-gathering machine merely suck the money from somewhere and funnel it somewhere else, collecting money for its various services along the way?

We don’t recall for how long the current format of fund prospectuses has been around. It was designed badly ab initio and it continues. If the market regulator has satisfied itself that fund prospectuses are fine documents, it should think again. Today, there is nothing to distinguish one scheme from another on the most vital aspects such as process of stock selection, track record of the fund manager and most importantly, back-tested results of a new fund idea.

Of all these factors, it is the third aspect that is most worrying. Fund companies are happily launching funds with different flavours but they have absolutely no obligation to show how these ideas would have performed under different market cycles in the past. But we have just discovered to our horror that there is a regulatory issue here as well. Nitin Rakesh, chief executive of Motilal Oswal Asset Management Company tells us that even if fund companies wanted to show back-tested results, they would not be able to do it. The Securities and Exchange Board of India (SEBI) does not allow it. A few days ago, we wrote about Motilal Oswal’s new fund idea ‘MOSt50’, which will be an exchange-traded fund and invest in 50 stocks according to their weights in a proprietary index called MOSt50, derived from the Nifty. This is called enhanced indexing.

The prospectus gives you no clue on how MOSt50 will be calculated. It wants you trust the fund blindly that it will give returns superior to Nifty’s returns. Maybe it will. But you have no way of knowing. A new simple idea like this can be easily back-tested. But no. “SEBI does not allow us to show back-tested results,” avers Mr Rakesh.

While an obviously valuable piece of information is kept out, funds are allowed to spike their offerings with any kind of flavour they like, no matter how ridiculous they sound. — Debashis Basu

Tomorrow: Bizarre fund ideas and what SEBI should do to control them