The mutual fund industry is again in the news, after Sebi, the capital markets regulator, revised the advisory committee and asked it to propose how to develop the industry.
MFs were earlier charging a load from investors, from which distributor commissions were paid. This created conflicts of interest, as distributors tended to sell products that benefitted them, rather than investors. Sebi ended this skewed structure and restored power in the hands of investors, who could choose their fund, buy from the distributor they chose, and pay what they thought adequate. Why, then, does this seemingly benevolent and correct approach to selling MFs need a review?
First, stringently righteous approaches aren’t always the best. If that were the case, stock exchanges would follow the model of the now closed OTCEI, which only had delivery-based electronic trades or markets entertaining only institutional investors, which were informed buyers and sellers. Both are righteous requirements, but impractical, as they would yield illiquid markets. A liquid market needs speculators who would buy and sell with limited information. They create noise and volatility, but also enable liquidity, the most important ingredient for an efficient market.
While everyone agrees that MFs are good investment vehicles, it would similarly be impractical to assume the product would reach investors without distributors. Much as we may complain about their quality and knowledge, the industry needs an army of distributors who will reach mutual fund products to investors. The basic flaw in the Sebi approach is the assumption that investors will adequately incentivise distributors to bring to them the right MF product. The highest incentive to spread the reach of MF products is with the producer, who is both able and willing to deploy an army of distributors to reach the products to investors. The regulatory requirement is about policing this army, just as the stock exchange regulates its brokers.
Second, regulating distributors is not an easy task, especially when one is dealing with ones who are already in business. Vested interests will try to continue to remain in business by circumventing the gate-keeping process. Distributors may also simply move out and sell products where entry barriers are low. Setting a tough qualification for distributors may create the same problems of the righteous solution we just discussed. Not all distributors perform the financial advisory function at the highest level of sophistication. A majority perform the simplest distribution function of reaching the product and completing the paper work. A small minority may manage the entire wealth of the investor. Setting a regulatory barrier for being a distributor will need this functional categorisation. Appropriate qualification requirements can then be set, so distributors are able to choose what they can best do.
Third, there are limits to assuming that financial products will sell on the basis of a pull (or demand) from investors themselves. Financial products take time to deliver on their promise, and investors do not have a proof of concept when they buy, unlike in a soap or shampoo. Delayed proof of concept means advertisement of performance can be misleading. The reason why the regulatory changes led to a serious drop in growth rates for the industry is the flawed assumption that push by distribution can be replaced by pull from investors.
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What is needed is the acknowledgement that MFs need a push by a better-regulated distribution force, that is adequately incentivised. As for investors being amenable to exploitation, it is time we stopped being overtly patronising. People make decisions about their cars, health and jobs, processing information before making a choice. Enable them to grow up to making informed choices about financial products, which are surely not more complex than the insides of sophisticated cars or human anatomy.
The writer is MD, Centre for Investment Education and Learning
