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New Mutual Fund Regulations at best Regressive

Posted in Finance Articles, Total Reads: 2869 , Published on May 07, 2013

Mutual fund industry in India is a mere blip when seen on a global scale. Even after almost fifty years of existence, the industry hasn’t been able to cut much ice with the retail investors or the ubiquitous “common man” of India. The savings rate of Indian populace is one of the highest in the world, hovering safely at more than 30% of the nation’s GDP as compared to a sub 5% rate in USA and UK which became the springboard to the economic recession that these countries find themselves in.

However, only 4% of the total savings of the Indians are actually parked into Mutual Funds, which have, over the last 3 years, clocked an average annualized growth in excess of 12% on both equity and debt schemes.

The industry has been brewing with new norms and regulations which have only aggravated the problem. It started with the ban of entry load in 2009 which saw a record closure of 19 lakh folios in one single year.  The equity MF collections in the year 2010 plummeted by more than 55% y-o-y. This problem has only been fuelled by the twin regulations which have taken effect from this calendar year. One of these regulations mandates decoupling of Mutual Fund agents from Investment advisors. The aim is to reduce mis-selling caused by the conflict of interest that arises when seemingly independent investment advisors unduly promote the products of the company that hands them fat commissions.

Independent Financial Advisors earn more than 75% of the total income from commissions while the 25% that they earn from advisory fees strictly comes from High Net Worth individuals. With this new regulation in place, all independent financial advisors shall be restricted from receiving any monetary or non-monetary incentives from product manufacturers (or AMCs). They would be required to charge only advisory fees from the clients they serve and would also be required to voice record and elaborately document the advice given to the clients. The idea of separately paying advisory fees is unfounded in the Indian context.

The first roadblock in buying a financial service is the difficulty in establishing the proof of concept. If you buy a cup of coffee, the first sip tells you whether it's the right product or not. When you buy a financial service, you do not know what to expect and find out whether you've made the right decision much later in the future. When you pay a financial adviser, you have no idea if the advice is of good quality and worth paying for. If you discover later that it's wrong, the damage is already done. Worse, the adviser has made his money while you have lost yours. The reluctance to pay comes primarily from the difficulty in trusting and buying a mere promise, whose quality is untested.

The second problem is the widely prevalent suspicion. If a financial adviser approaches you with his proposition, you may already be cynical. This means you typically deal with multiple advisers and are unwilling to consolidate and provide complete data to a single adviser who can manage your wealth to meet your goals. You are also suspicious that he is selling products, not advice. This suspicion increased significantly after financial advisers rampantly mis-sold bad mutual fund NFOs, PMS products, structured products, real estate funds and insurance products to a large number of gullible investors. Also a fee based system would incentivize servicing only the richer clients thus leaving the retail populace in the lurch. 

It must be understood here that the penetration of Mutual Funds in the country has been largely restricted to the top 5 cities of India which account for more than 70% of the total collections. Also one supposed shortcoming of this regulation is that the client has to pay a charge under the fee-based model regardless of whether the given recommendation is followed and the money invested or not. Indian MF industry cannot be compared to UK, USA or Australia. The per capita income in these countries is not only way higher but also their financial markets have achieved greater depth complemented by considerable level of financial literacy among their retail investors. Investors in these markets are more tech savvy, more aware and more experienced. They pay a minimum investment amount of $1000 along with advisory fees, entry load, transaction fees, etc, all of which is absent in India.  For example, in the United States, the average expense ratio is 1% p.a. which contains a 12b-1 fee approximating to 0.35% which directly goes into the distributors’ pockets. Moreover, an entry load equaling 2-3% is also charged on the investment made. Over and above these fees, the financial advisors in the US also receive negotiated advisory fees which range from 1-1.5% of net assets. This is certainly a far cry from a trifling 2.50% expense ratio in India with no entry load or advisory fees. An inconsequential amount equaling Rs.150 is levied as transaction charges for bringing in new investors, if it really merits any mention. Moreover, the financially rudderless retail populace of India would prefer a one-stop solution to its investment needs rather than being separately put under 2 different umbrellas; one that of the distributor and the other, that of the advisor.  The removal of entry load ironically counters the founding premises of this set of regulation. Without a uniform load for entry, there will be more competition and poaching of agents by AMCs which in turn would be counterproductive to the interests of the ignorant investors.

Another regressive set of regulation that has crystallized in the last month is the mandatory direct distribution model for all AMCs so as to encourage investors to go direct in the lure of 0.2 to 0.4% of savings on commissions. It must be understood that distributors are the pulse of any industry, particularly in a geographically and culturally scattered country like ours. In fact, even in the field of medicine, doctors act as nothing but distributors for the pharmaceutical companies which cannot sell their drugs to the consumer directly as the patient desires consulting a doctor and buying only the prescribed medicines. So apart from the distribution of the product, the advice given by the distributor is also very valuable, especially products and services which may be complex or difficult to understand for the lay man. There is only one doctor for every 25,000 people in rural areas compared to one doctor for almost 500 people in urban areas.

The direct consequence of this is that the rural spending on heath is $2 per capita as compared to $36 in urban areas. The slow growth of E-commerce in India is another testimony to the importance of distributor presence in the value chain. Internet penetration in India only recently crossed 100 million users! However, number of online buyers stays put at around 10 million. A distributor is functioning as an advisor, a seller of the product as well as creating convenience for the end users. So when we talk about a financial product it is nothing different from an FMCG product or a car. The ramifications of the entry load ban as mentioned above clearly epitomize how indispensable are distributors in the MF value chain. Another case in point is the resounding failure of the New Pension Scheme in our country.

After seven years of being open to government employees and two years to the general public, the funds under management are an underwhelming Rs 8,585 crore. While 12 lakh government employees have been enrolled, there are apparently only 50,000 members from the general public. The scheme is sold through POPs which are nothing but financial intermediaries selling the schemes and managing the corpus of the public.  However, no one is willing to sell this scheme considering its fund management charges being disparagingly low at 0.00010% and transaction charges being just Rs.40 per application. This low incentive structure has been the undoing the NPS as the PFRDA feels that the distributors are not interested in selling the low-cost scheme. The same fund management fees for distributors in Australia is 0.7% owing to which it sees pension fund assets equaling more than 100% of its GDP as compared to India’s pension assets at just above 5% of the GDP. Arguably so, so far only 0.037% of the total workforce has enrolled in NPS, leaving aside the government employees. Even in the United States, where the financial literacy is very high, there is still majority of retail investors who prefer investing through financial intermediaries or sales channels. Just above 20% of investors actually take up the direct channel in USA. Take the case of Quantum Mutual Fund, the only AMC in India to sell its products directly. Its AUM in September 2012 was 216 crores finishing 43rd out 44 AMCs. Thus, distributor presence is a pre-requisite in a financially illiterate country like India. These regulations are undoubtedly breathing down the neck of India’s MF industry.

This article has been authored by Harsh Gandhi from K.J.Somaiya Institute of Management Studies & Research.

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