Joydeep Ghosh: Band-aids won't do for mutual funds

Last Updated: Thu, Jul 19, 2012 04:39 hrs

Securities and Exchange Board of India (Sebi) Chairman U K Sinha says there is just no place for 41 mutual funds in the country. "Everyone is opening a mutual fund these days - it's almost like a game; if one bank or brokerage opens a mutual fund, the other rushes to do so. The low entry barrier [Rs 10 crore] is the reason for this," Sinha said.

The regulator has a point. Even though 24 of the 41 are in the red, three more fund houses have started operations in the last 15 months. These include Indiainfoline Mutual Fund, Indiabulls Mutual Fund and Union KBC Mutual Fund.

Sinha didn't stop at that. Sebi, he said, would like to "engage" with the management and trustees of nine asset management companies whose majority of schemes (over 50 per cent or even all the schemes) have been underperforming their respective scheme benchmarks for three years in a row. In nine others, 50 per cent of schemes have underperformed their benchmarks for three years. "There can be short-term blips, but consistent underperformance is a matter of serious concern," Sinha added.

That concern about the industry in general has now reached the Prime Minister's Office. The PMO is looking at how to address the sluggish growth in the mutual fund industry, which has seen even biggies like Fidelity and Standard Chartered exit the scene. The solutions being talked about include possible sops on offer, increasing the expense ratio by 0.25 per cent or more, flexibility in using the expense ratio and passing the service tax burden on to investors.

Flexibility to use the expense ratio would help big fund houses substantially. Many of them already have profitable schemes that can be ploughed back into marketing. This would become a sore point with those small fund houses that haven't accumulated money in their schemes. Raising the expense ratio would help all players, but it will be a small step for the 44-player industry. "Playing around with margins or allowing fungibility will be fringe benefits for the mutual fund industry," said Sandeep Parekh, former Sebi executive director and lawyer. The solution, therefore, is not so easy.

Transferring the burden of service tax on investors will increase the cost of buying mutual funds, and this is something that many investor associations will hate.

But all these will be just band-aids - simply hiding the wound for some time while the long-term ailment remains. The root of the problem lies elsewhere: there is absence of uniformity across various financial products. Retail investors who enter the financial market have broadly four choices: direct equities (cheapest but riskiest), insurance (comparatively expensive - costs can be as high as 30 per cent of the first-year premium), debt (safe but does not beat inflation) and mutual funds (cheap and safe, but in a mess).

The Union finance ministry had taken this issue to the High-Level Coordination Committee (HLCC), which set up a committee under Dhiren Swarup, former chairman of the Pension Fund Regulatory and Development Authority (PFRDA). The committee, which presented its draft guidelines four years ago, argued that the same rules should apply to pensions and insurance. The committee recommended that agent fees in insurance be scrapped completely so as to bring it on a par with the mutual fund industry. However, there has been little discussion on the report.

As Parekh puts it, "Implementation of the Swarup Committee report is a long-term solution which will require Parliament's nod. Otherwise, every regulator will protect its turf."

Former Sebi chairman C B Bhave actually went the other way. Instead of protecting his turf, he chose to take the hard decision of banning entry loads in 2009 - a move that he might have hoped would encourage other regulators to follow suit to protect investor interest.

However, that did not happen. While the Insurance Regulatory and Development Authority did cap charges on unit-linked insurance plans (Ulips) in 2010, distributors have shifted to traditional products – money-back and endowment policies – in which they continue to earn a good percentage (15 to 30 per cent) of first-year premiums. Even distribution costs of Ulips are substantially higher than those of mutual funds.

Consequently, there is serious arbitrage between mutual funds and insurance schemes because of their respective regulatory stance.

The solution, obviously, lies in the removal of arbitrage between financial products. Though the implementation of Swarup committee recommendations – banning entry loads in both insurance and mutual fund industries – may not be possible immediately, by introducing a uniform distribution load, whether entry or otherwise, the customer and distributor can be made indifferent to buying and selling. This will allow buying or selling to occur on the basis of need, and not fees.

Also, there are certain unique problems that make the mutual fund industry unattractive, especially in adverse market conditions. For instance, transaction costs. Index funds, which replicate benchmarks and are most popular in developed markets like the US, cost investors just 25-27 basis points. In India, these schemes can cost anywhere between one per cent and 2.5 per cent, which makes them at least four to 10 times more expensive. Performance-wise, many index funds give returns that can be five percentage points lower than the benchmark. Globally, any difference over 0.5 per cent would be considered blasphemous.

Also, the investor is often confused because there are too many fund houses with similar schemes. According to the CEO of a leading fund house, "The top 10-15 fund houses have made serious money in this business and the return on equity for big fund houses has been almost infinite. Due to this, many new players want to enter this business." Consequently, the divide between big and small fund houses is almost like Indian demographics - the rich are too rich, the poor are too poor.

The mutual fund industry requires serious changes. And solutions, as Parekh puts it, do not lie in fringe benefits. Instead, the government, in consultation with Sebi, needs to put in place serious guidelines to make the industry more investor-friendly. The simplest and quickest solution is: introduce economic reforms fast. This will boost stock market sentiment and people will rush back to equities. Who, then, cares about guidelines?

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