Lowering investment costs

A simple idea that is well appreciated worldwide is the importance of fighting fees and expenses in fund management. Good returns in fund management are a possibility, but the fees and expenses paid are a certainty. The international evidence suggests that paying more for fund management generates reduced returns. A remarkable twist to this tale in India lies in the "distributors", or agents, who sell fund management products. Fund managers have resorted to making very large payments to these agents, to the point where the profits of the agent sometimes exceed the profits of the financial firm. The chief executives of financial firms privately gripe about this state of affairs, but have not been willing to break with the existing system. As a consequence, customers of mutual funds, and particularly those of insurance companies, are getting a poor deal. All too often, customers of insurance companies are blindly placing money in schemes with the intention of saving taxes, and ending up fuelling the profits of the agent who is selling them the scheme. The non-transparency and high charges that are in place with most mutual funds, and particularly with insurance companies, fuel the discomfort of critics of modern finance, who see "professional fund management" as a way to channel the money of ordinary citizens to financial fat cats.

Exchange traded funds (ETFs) are a promising way out, because the customer is able to go to a stock broker to get invested, and stock broking is a transparent, competitive and efficient industry with very low charges. The lowest-cost fund management accessible to an individual in India is the ETF. Only one active management vehicle "" Quantum Mutual Fund "" has broken with the agent system, and has so far experienced limited success.

The Securities and Exchange Board of India (Sebi) has now proposed that customers be given a zero-cost alternative whereby they are able to use the Internet and get their money to the mutual fund while bypassing the agent. This is a sound initiative. The insurance regulator, by way of contrast, has offered no positive proposal for addressing the egregious practices of insurance companies. However, the essence of the problem lies not in tweaking the agent system but fundamentally re-shaping the fund management industry.

The New Pension System (NPS) represents an effort at using public policy in order to address the market failures of the fund management industry. In the NPS, the selection of fund managers is done on the basis of an auction where the sum total of fees and expenses is stated up front by the fund manager. This ensures that customers get low prices. Centralisation of record-keeping at the "Central Recordkeeping Agency" (CRA) and an unbundling of customer front-ending to Points of Presence (POPs) help to reduce dramatically the costs of bulk fund management. In a recent auction conducted by the Coal Miners Provident Fund, the winning bid was as low as one basis point of assets per annum.

Many details remain to be worked out "" how the CRA will operate, what the charges of the CRA and the PFMs will be, how POPs will be incentivised in a way that avoids the flaws of mutual funds and insurance companies, and how every detail of operation will be structured so as to constantly put pressure in favour of obtaining low fees and expenses. The onus is upon the ministry of finance and the pension regulator to translate the promise of the NPS into reality.