This is a wake-up call for all risk-averse investors who park their money in mutual funds and quietly snooze, comforted by the thought that their investment will grow without any pangs.

There’s been a massive churn in mutual fund portfolios lately; big investors have been flitting in and out of funds, sparking a sharp volatility in the amount of money that fund managers can invest in the markets.

Do you need to worry? You bet! The asset churn has started to nibble away at your returns and it’s just possible that some of your investments may be treading water.

You should be aware of the risks you now run by sticking around in a fund that will provide anaemic returns as its assets under management (AUM) — the industry jargon for cash in its treasury — start to shrink.

Last week, Sebi chairman M. Damodaran expressed strong misgivings about the way companies and large industry houses were parking surplus cash in mutual funds and skimming profits by diving in and out of funds.

It’s really a Catch-22 situation for the mutual fund industry: they can’t do without corporate investments. If they keep them out, they won’t have much of a cash pool anyway because households park only 5 per cent of their overall savings in mutual funds. But if they let the corporate fat cats in, they will have to live with gut-wrenching volatility in their AUMs.

Old game, new high

Fund flitting has always been around — it’s the oldest game that big investors play in the sector. But this time the scale has hit a new high. Take a look at the numbers: the domestic mutual fund industry witnessed the highest-ever inflows of Rs 2,89,546 crore in May — Rs 2,74,073 crore into the existing schemes and Rs 15,473 crore into new schemes.

But the bad news is that there were huge redemptions as well which restricted the net inflows into mutual fund schemes to just Rs 55,128 crore during the month.

In fact, there was a net outflow of Rs 286 crore from equity funds last month because of heavy churning of investments by investors from existing schemes to new fund offers. Investment churning not only restricts the growth of the assets under management of a scheme, but it also pulls down the rate of return.

The AUM of all equity schemes was Rs 93,748 crore, or 34 per cent of mutual funds’ total AUM (Rs 2,76,343 crore), as on May 31, 2006.

By the end of May this year, the total AUM of mutual funds grew by almost 50 per cent to Rs 4,14,172 crore. But the AUM of equity funds grew at a sluggish pace of 31 per cent to Rs 1,22,800 crore and accounted for 30 per cent (34 per cent last year) of the total AUM of mutual funds.

The slowdown in the growth of equity funds is puzzling when you consider that 90 lakh new investor accounts were opened with fund houses last year (the total number of investor accounts with mutual funds now stands at 1.3 crore).

A 31 per cent growth in AUM when juxtaposed against a 42 per cent return from the sensex during the same period implies that investors who stayed put with their investments in the growth schemes of mutual funds didn’t make as much gains as they could have by investing in stocks directly.

Lower returns

An illustration (see inset table) will help you understand how churning eats into your mutual fund returns.

Let’s assume a mutual fund starts with an asset size of Rs 1 lakh. The initial net asset value of units is Rs 10 each. The fund generates an annual return of 10 per cent. Let us also assume that the fund house redeems 1,000 units every year. It also gets investments of Rs 10,000 each year.

If you had invested Rs 1,000 in this scheme, your investment will grow to Rs 1,480.26 after five years. This is lower than what your initial investment should have grown to (Rs 1610.51) at an annual compounded growth rate of 10 per cent.

At the end of the first year, the AUM of the fund stands at Rs 1,10,000 growing by 10 per cent. The fund then faces redemption of 1,000 units and inflow of Rs 10,000. Following the redemption, the AUM becomes Rs 99,000. The fund then receives investments worth Rs 9,775 (= Rs 10,000 minus 2.25 per cent entry load). The AUM grows to Rs 1,08,775. At the end of the second year, the AUM grows to Rs 119,652.50 and the NAV of units to Rs 11.96. The same process follows in the subsequent years.

Now, look at the returns. The absolute returns increases to 48 per cent in five years, but the compounded annual return keeps on declining every year. Though the fund is generating a 10 per cent compounded annual rate of return, your investment grows only at the rate of 8.16 per cent every year over five years.

“Generally, the churn is more in schemes giving lower return than others,” said Syed Shahabuddin, managing director of SBI Fund Management Pvt Ltd. “Corporate and institutional investors have their own professional treasury managers and their job is to maximise the investment returns of the company. They keep on switching between funds,” he added.

“Retail investments are sticky money — they (retail investors) do not enter and exit schemes frequently — institutional investments are not. Besides, retail investors have to pay an entry fee every time they invest in a scheme,” said an official of UTI Mutual.

Cut in commission

Corporate investors do not have to pay any entry fee. Besides, the distributors try to entice them with a cut in commission. If an institutional investor who is investing Rs 5 crore, say, gets a commission cut of 0.5 per cent, he/she will be more than happy to exit the fund after a month or two at a unit NAV of Rs 10.50. Because this would give the investor a total return of Rs 550,000 — Rs 50,000 as commission cut and Rs 500,000 from sale of units — in two months. The rate of return is 5.5 per cent in two months, or 11 per cent annually.

Next week we shall discuss the options one has to beat the churn.