They are the new wonder boys. After software, they are touted to be India’s new export kings. Magazine cover stories extol their powers. Their coffers are being filled by the promise of high tax-free returns, which are promised to be annually more than the promise, nee guarantee, of provident fund returns of 12 percent per year. Please welcome the money managers at India’s mutual funds.

The Indian stock market did well last year, after a depressing 1998. The highly misnamed barometer, Sensex, rose 64 percent in 1999 and only 37 % over end-1997. If investors are making money, what's wrong? What's wrong is that the investors in growth-oriented mutual funds should have made a lot more, about 250 percent, in the two years ending Dec. 1999!

How can one prove such an outrageous accusation? By looking at the counter-factual. By looking at the returns of a Fool's Index (FI). By looking at the stock-market in terms of the new economy cold-is-hot ICE (information, communication and entertainment) and non-ICE stocks, rather than comparing it with the badly selected, nee senseless, Sensex or the Babu-improved, but still deficient, NSE-50 index.

A well-constructed Fools Index should reflect the decisions of a naïve, non -professional investor; an investor who occasionally reads the newspapers, and knows little about the intricacies of high finance. Someone like you and me. Such an investor will only buy a few stocks, say 10. These stocks will be "household" names. What stocks would she have heard of in end Dec. 1997? The ones with maximum sales (in their respective sectors) in 1997. This selection would lead the Fools to invest in the following: BHEL, Reliance, Telco and Tisco; Hindustan Lever, ITC and Tata Tea; Ranbaxy and SBI. Notice that not a single ICE stock is present. In addition, in 1998, even the most foolish investor would have heard of Infosys. Knowing a little about diversification, and being super-cautious, the Fool would only invest Rs. 10 (of a Rs. 100 portfolio) in each stock; thus, only 10 % of her portfolio would be devoted to the new economy ICE stocks. (Only a year later, in early 1999, ICE stocks were rapidly becoming a large part of most mutual fund portfolios - and considerably greater than 10 percent).

The Fools Index is a genuine retail mom-and-pop index i.e. a perfect benchmark which can, and should, be easily out-performed. Especially by professionals whose full-time job it is to manage money; and especially by the whizzes at the mutual funds whose importance was elevated by the Indian government last year as they got the prize status of no-taxation on profits. Note this anomaly and see if it makes any sense - if you give your hard-earned money to high-cost mutual funds, then you pay zero taxes on your capital gains, but if you use your own brain to invest, or are chary of giving mutual funds fees ranging from 4 to 8 percent for the privilege of under-achieving a fools index, then you pay taxes at 33 percent. And this they call an important financial sector reform!

The table reports the performance of various categories of mutual funds for the period 1997-1999. The principal of equal weights is retained throughout e.g. if UTI had 18 equity funds operational in Dec. 1997, then each fund has a 5.6 % weight in constructing the gains for UTI. The Fools stocks show a return of 248 percent for the two years. Three years makes the comparison considerably worse for the mutual funds, one year not considerably better. Two of the biggest FII's - Morgan Stanley and DSP-Merrill Lynch - report returns considerably below the Fools Index - 143 and 167 percent respectively.

A staggeringly small number of growth oriented mutual funds beat the Fools Index - twelve out of 118. Only two public sector funds outperform, and none of the 18 UTI funds do so. Less than a fifth (7) of the 38 info-tech and otherwise worldly savvy FII funds outperform the Foolish Incompetent Investor. Perhaps most of the FII's value-added is in setting up a distribution network, with the prizeworthy "foreign" attached to the name - not entirely unlike unscrupulous fly-by-night firms putting software in their name.

What's going on? Where have all the profits gone? "Objections" to the above analysis can be that it assumes a 10 % investment in an exceptional ICE stock like Infosys. This choice biases the performance downward; in contrast to Infosys's 2250 percent rise, Wipro rose 2740 percent, Satyam 2470 % and Zee Telefilm 11,500 percent. The CMIE software index rose by 4400 percent during the same period. A more sophisticated, but equally apologetic, objection is that the ICE stocks were not part of the Sensex or NSE in 1997. This is more a comment on the political nature of the indices; further, this argument is akin to stating that US mutual funds restrained themselves from investing in AOL or NASDAQ stocks till they become part of the S&P 500!

What policy implications follow? Several. While mutual funds have obtained an egregious tax-benefit, they have not rewarded the investors with even foolish returns. If tax-policy favors investments in equity (and there are good reasons to do so), then all investors, and not just high-cost mutual funds, should have tax-free status. Second, more competition, and considerably more disclosure, is needed from the mutual funds industry. There are more than 400 mutual fund "families" serving the needs of 80 million investors in the US and less than 40 serving the needs of about 40 million investors in India. On disclosure, more, much more needs to be done. Even otherwise savvy brokers do not know that no-load mutual funds are allowed to charge, to their NAV's, upto 6 percent by SEBI as operating expenses! Display of expense ratios should be mandatory as well as display of returns, and display of whatever index the mutual fund scheme considers as its benchmark. The bottom line - let there be transparency, fairness and competition in the stock market - as there is in the fish market.