Debashis Basu: Sebi's poisoned chalice for MFs

Last Updated: Mon, Sep 03, 2012 05:33 hrs

Consumer durables and consumer products companies have to mention their prices on the packaging. It's the law. For financial products, finding out the charges is less easy. You have to struggle to figure out the exact interest rates you are paying for loans, credit card dues, insurance and mutual funds. Most people don't try. They pay up. Financial services companies know this and sometimes sneak in a clause to make a windfall gain - for example, inserting a small charge of Rs 99 into the credit card statement of millions of customers. A very small number of people complain and get their charge reversed. Others ignore it. Companies take advantage of this. Sadly, the Securities and Exchange Board of India (Sebi) has just helped the mutual fund industry do exactly this.

About two weeks ago, Sebi announced a convoluted and half-baked formula by which mutual funds would now be allowed to charge more. Some commentators have called this a game-changer (yes, the game is even better for fund companies) or pointed out how Indian mutual funds are among the cheapest in the world (no, they are not, and it does not matter anyway). A few cynical others saw through this formula and concluded that it was another example of how the regulators always work for industry and against the interests of small investors. After all, the stark fact is that Sebi's move will transfer more money into the pockets of fund companies from those of investors, with no additional benefit to the latter.

The attitude of regulators to potential malpractices has been: buyers beware. Read the fine print. Ask questions. Most people don't - not because they are stupid, but because we are never so rational about money. It is another matter that regulatory officials themselves may get taken for a ride when they act like normal savers and naturally don't read the fine print either (they may then use their muscle to set things right for themselves).

In the US, which has shown itself to be clay-footed when it comes to protecting investors from wrong practices, administrators of retirement plans have to disclose a breakup of the costs to the firms whose employee funds they manage. By the end of August, the companies were supposed to disclose the information to participants.

This shows that the regulators have not focused where the problems are. When it comes to financial services, Economics 101 may not work. There are 44 fund houses. Not one has broken ranks about products and costs. Everyone is peddling the same thing. Competition has not worked to create differentiation. And when it comes to investor protection, disclosure plays a limited role.

Whether it is the fixed expense ratio that Indian fund companies have been allowed to charge, or the detailed cost of retirement in the US, regulators are still in the era of working with market participants to tweak existing structures and products, assuming that investors would read the fine print of dense legalese.

They will not, and will be forced to pay ridiculous amounts of money to mutual funds for very average performance. What Sebi has just done is one of the most regressive of acts. The fund industry should be wildly happy. Unfortunately, that happiness will last only for a while. What Sebi has handed over to the fund industry is a poisoned chalice. How so, when I assume that investors usually don't understand the importance of costs and don't read the fine print?

Here is another thing regulators don't pay attention to. Just as investors do not care to read the fine print, they are all equally indifferent to differences in product features. Just as they are indifferent to small differences in costs, they are indifferent to small differences in returns too.

Here are some facts. Fixed income assets barely deliver returns above inflation or bank fixed deposits - yet mutual funds lop off 2.25 per cent as their charges. The expense ratio charged for index schemes is a total rip-off. All the fund manager needs to do is to invest blindly in the stocks according to their weightage in the index. For such astute stock-picking skills, US index funds charge 0.25 per cent. Indian index funds charge 1.5 per cent, six times more! In fact, it used to be 2.5 per cent until former Sebi chairman M Damodaran brought it down to 1.5 per cent just about five years ago.

Nearly 80 per cent of the schemes charge an expense ratio between 0.15 per cent and one per cent, which is a ridiculously wide range by itself, but there are a few schemes that have expense ratios above one per cent and going up to 2.25 per cent! Imagine a scheme that returns just around six per cent per annum to buy a few safe short–term papers, unaffected by interest rates - and, out of that, one to two per cent is deducted by the fund company!

But didn't I say investors don't pay attention to costs? They don't, but they can certainly see the outcomes of higher costs and act accordingly. They have concluded – quite correctly – that a large number of equity funds don't deliver great returns and bank deposits are better options than fixed income schemes of mutual funds. On top of this, if mutual funds, which are already overcharging customers, are allowed to charge more, investors will do more of what they have done so far: keep their money in banks, gold and real estate. Fund companies may learn a lesson later, but who said salaried employees have anything to lose?

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