It is an opportune time for the mutual fund industry and the regulator to sit together and work out changes in an atmosphere of trust.
Mutual fund houses in India are feeling unloved. Having been in this state for close to a year now, they, along with their distributors, are in a state of lugubriousness, of the type generally associated with a severe absence of vitamin B. The reason can be broadly attributed to the abolition of the entry load for mutual fund schemes by the securities market regulator. They are up in arms against the regulator. Their initial rumblings have grown to high decibel levels in the past few weeks. Two camps have now emerged — the regulator and the regulated; contrary arguments are being drawn from the respective quivers; points of views have hardened; it’s “us” versus “they” now. There are bystanders who are enjoying the ringside view and betting on who would wink first. But this is not a desirable situation for the industry and the investors, as the prevailing uncertainty, if prolonged, could be hurtful to both. This should end.
The arguments of the mutual funds “industry” seem to be moulded in the classical Stigler’s model of economic regulation: “A regulator faces special interest pressure from producers and consumers. The special interest pressure is always more ‘persuasive’, so producers always win. Regulations are passed only for the benefit of large firms, not for the benefit or protection of consumers.” But, two decades of our stock market history would bear testimony to the fact that such stand-offs have hurt the regulator less and the market and the market participants more. Market development has been stalled in the bargain. At the same time, it has generally been found that the securities market regulations in India have been acceptable and sustainable whenever these have been co-created by the regulator and the market participants, and not unilaterally thrust upon them. But the same history also teaches that contumacious attitudes of the intermediaries and market infrastructure institutions have often cost them dear. Several market infrastructure institutions have fallen by the wayside or lost in competition because they considered a development measure to be a battle and discovered very late that they were on the wrong side of it.
Payouts and commissions paid by the mutual funds seem to be the root cause of the stand-off. The regulator, who is charged with a statutory responsibility for investor protection (and, of course, market development!), has little choice but to discharge that responsibility and is asking for greater transparency in the matter of payouts and commissions. It perhaps believes that, at present, there is a lack of such transparency especially in the manner in which entry loads have been utilised and, consequently, the investors’ money has not been employed for their benefit. The industry, on the contrary, believes that payouts and commissions are an integral part of the mutual fund business and abolition of entry loads has hamstrung growth of the industry. The common statistics which are being pulled out in support of their argument are the closure of folios in the past few months and the drying-up of funds flow into new schemes. But, these conclusions are the result of very selective analysis of mutual fund data available on the website of the Association of Mutual Funds in India. Fund houses are hopeful that painting a dismal picture of doom and gloom may perhaps lead the regulator to soften its stand and, maybe, with a gentle nudge from the government. Some are also hopeful that given their persuasive power (read clout), the distributors may even persuade the government to intervene. But, just for memory recall, when the FII guidelines were established in 1992, it was predicted that the guidelines would be a severe deterrent for their investment; when dematerialisation was introduced in phases in 1998-99, it was argued that it might kill the market. When rolling settlement was introduced in 2001-02, it was proclaimed that liquidity would completely dry up. As it is now known, that none of these apprehensions had the same power of the Paulson’s oracle. Of course, the regulator in each of these cases did take the market into confidence before announcing these measures and gave the market sufficient time to adjust.
But, who are these payouts and commissions being made to? To the distributors of course, because we are told that they hold the key to the marketing and sales of mutual fund schemes. Fund distribution has grown as an attractive line of business, but only in the recent years. This is a heads-I-win-tails-you-lose business. Distributors selling mutual fund schemes get a commission every time you put money in a new fund offer; invest in an existing scheme or even stay invested in a scheme that you have invested in before. To remain competitive, asset management companies try to outdo each other for higher share of assets under management. They depend on the distributors who have lower cost structures than the fund houses; their major overhead is the salary, commissions and incentives paid to their employees. They often earn more than the fund houses from the same business. But who are these distributors? The top 15 who would account for the lion’s share of the business are several large private-sector domestic and foreign banks as well as financial conglomerates who also have fund houses in their fold. Who is paying for all this? The investors of course, out of the entry load. So, why on earth would the distributors let go of the lucrative business? “Carpe diem, seize the day!” is contextual and makes enormous sense for the fund houses and the distributors. After all “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.
The dominance of the distributors in the growth of mutual funds in the last few years impacted the quality of the growth of mutual funds. For one, there is a lack of product innovation — the schemes of mutual funds have proliferated without real product differentiation. This makes the choice of investors difficult. It’s always “twee deedle dum twee diddle dee”.
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Second, the mutual funds have not explored untapped markets in the country, since the distributors bring major business easily from the top-10 cities.
Third, companies account for a major share of the aggregate investments (AUMs) of all schemes and certainly of the income and gilt schemes. The retail investors are more in number and have the lion’s share of the portfolios and cost of servicing them is high. But, the retail investors have made good money in equity schemes, which shows that if efforts are put in by the fund houses, the retail market can offer a sustainable advantage to the fund houses for discovering fortune at the bottom of the pyramid. It is here that innovative business strategies should have mattered. It is here that the mutual funds are missing an important opportunity for long-term sustainable growth.
Changes are necessary and changes will cause pain. It’s not just the change itself, but the way it is made that is important. Changes that are implemented in an atmosphere of trust, and are not done piecemeal or thrust upon, make for an efficient and sustainable change management. Many years ago, there was paper “Mutual Funds 2000”, which helped carve out reforms in mutual funds and the regulatory framework. Ideally, now is an opportune time for the industry and the regulator to sit together and work out a Mutual Fund 2020 paper and charter future growth of mutual funds in India.
The author is a former executive director of the Securities and Exchange Board of India and is currently associated with the IFC’s Global Corporate Governance Forum of the International Finance Corporation and the World Bank
Views expressed are personal pratipkar21@gmail.com