* Net selling second highest on record - Daiwa
* Industry freezing toushin sales after FSA criticism
* Toushin sales likely to be lacklustre this year - Invesco
* Funds with monthly payout hit hard
By Tomo Uetake
TOKYO, June 8 (Reuters) - Japanese investment trusts, or "toushins", sold the second largest amount of domestic stocks in 13 years in May, in the strongest sign yet that criticism of the industry by the country's financial watchdog is taking a toll on their activities.
Toushin fund operators sold 269.2 billion yen ($2.46 billion)of cash stocks last month, data from the Tokyo Stock Exchange showed on Thursday.
That was the biggest monthly net selling since September 2014 and the second-highest on record since data began in the current format since 2003, according to Daiwa Securities.
It is not atypical to see selling from toushin when Japanese share prices hit highs. Many Japanese investors, unconvinced of the strength of the country's economic recovery, are eager to sell into rallies and book profits.
But money managers are also smarting from paralysis triggered in April after Nobuchika Mori, the commissioner of the Financial Services Agency, blasted the Japanese asset management industry for neglecting the true interest of their customers, industry sources said.
Mori's criticism was wide-ranging, from funds' high fees and low investment returns to the industry habit of encouraging retail investors to switch funds often, a practice that helps the financial industry rake in more commissions to the little benefit of investors.
Mori's tirade prompted many asset managers and financial institutions to refrain from aggressive sales of toushins since April.
As a result, new fund inflows into toushin dwindled, while retail investors pulled out money out of Japan stock funds to lock in gains after a market rally, leading to large net sales of Japanese stocks by toushin operators.
"Individual investors are cautious on the whole. The asset management industry is also shrinking back because of the criticism on the industry," said Alex Sato, President and CEO of Invesco Asset Management Japan.
"It's hard to sell toushin in the middle of a major business model changes. Unless we see a robust rally in Japanese stocks, it will be hard to expect a strong toushin sales this year," he added.
Japan's Nikkei average hit 1-1/2-year highs in May and it has extended gains so far in June, breaking above the psychologically important 20,000 mark.
"Investors seem to have locked in profits," said Masahiro Suzuki, senior quantitative analyst at Daiwa Securities. "It's quite common for toushin investors after rallies."
Mori also railed at a type of funds that pay dividends to investors every month regardless of funds' performance.
While they have been popular among investors, especially pensioners, financial experts agree the products make little economic sense because investors cannot reap the benefits of higher compound returns.
Many asset managers were forced to cut their dividend payout ratios lately, partly in response to falling returns, but also following the public reprimand from the FSA.
Yasumasa Nishi, president and CEO of Asset Management One, said many asset managers, including his, are reducing monthly dividends on those products, resulting in sharp falls in their sales.
"This is tough for sales staff but we are being hit by the wave of normalisation of payouts and this process has to continue," he said. ($1 = 109.49 yen)
Reporting by Tomo Uetake