03 October 2012

Mutual fund industry – SEBI’s steroids?

I have a piece in the current issue of Outlook Business (13th Oct) on the recent modifications of the regulatory structure of the mutual fund industry by SEBI. Here is a link to the original. Here is the full piece:

The SEBI board made some significant decisions in its latest meeting regarding regulation and development of the mutual fund market. While SEBI is the securities market regulator, the preamble of its parent Act also envisages a developmental role for the statutory organisation. While it is rarely the case that SEBI needs to balance its regulatory and developmental role, a case like mutual fund industry surely falls into that category. In the board meeting SEBI has very delicately balanced the its two roles and the tension between the two roles is clear to those who have read commentary on the issue. Many have criticised SEBI for not going far enough and many have criticised it for going too far. To put it more clearly, though somewhat simplistically, SEBI needed to balance the interest of the investors by keeping a ceiling on expenses which could be charged to them and play a developmental role by increasing the ceilings so that funds are sold by distributors. The latter is clear to those who have observed how distributors have abandoned mutual funds in favour of more lucrative products which fall within the domain of another regulator. This piece analyzis this step by SEBI in a more granular and detailed manner.

SEBI has increased the permissible expense ratio which the asset management company (AMC) charges to the fund (and  therefore to the unit-holders). Clearly, higher expenses for funds take away money from investors and by increasing the expense caps, one could argue in the absence of other facts, that SEBI has taken an investor unfriendly action. However, the context here is crucial. The mutual fund industry has been injured on several counts, many of which were driven by the regulator’s attempts to curb mis-selling of funds. SEBI for instance stopped the charging of an entry load on funds which was collected and given to distributors (those who go out and sell the funds) because it found that this benefit given to distributors creates the opportunity to mis-sell a mutual fund by pushing investors to sell an existing fund and to buy a new fund, solely so that the distributor gets an additional commission. In regulatory parlance this practice is known as churning.

Given this barring of entry loads, distributors not only got less commission, but also continued to get juicy double digit commissions on sale of other financial products like insurance linked funds. Since funds are sold rather than bought, i.e. people buy funds based on the marketing effort of distributors rather than purchase it otherwise, this led to the abandonment of the mutual fund market by distributors. On the other hand, because of the rather dismal equity markets which were in turn reflected in the mutual fund performance, investors who had lost money because of an adverse market also chose to abandon the mutual fund route besides other equity investments. The result has been a steady decline in the assets managed by the mutual fund industry in India over the past several years.

SEBI thus had a delicate task of getting more distributors to play ball without running over the investors, whose protection is SEBI’s key task. Thus increasing the ceiling in expense ratio by 0.20% was SEBI’s chosen method of altering the current cap to incentivise the distributors who are expected to now sell the fund units.

The second decision by SEBI is that it has allowed an additional increase in the expense cap charged by the AMC to the mutual fund if it is able to garner funds from smaller towns. Where an AMC is able to raise over 30% of its funds from beyond the top 15 cities, it would be able to charge an additional 0.30% fee. This additional expense will not be binary. So for example an AMC gets only half the targeted amount (15% of the fund value) from smaller tier cities, it would still be permitted a 0.15% increase in expenses. Thus an AMC would get a higher expense if it has the ability or takes the pains of going beyond the lucrative large cities. This move has two impacts. One on the investor, and the other one on the AMC. Investors will need to bear a larger burden because the higher expense will come from their pockets for compensating  the AMC. However, the amount of incremental expense is not substantial and  is unlikely to substantially impact investors adversely. From the AMCs perspective, there are both costs and benefits involved. Clearly, the large cities are the easy markets with higher disposable income. To go beyond them would require substantial expense and consume time, though trying to tap this untapped market would come with the benefit of a higher expense ratio. Each AMC will need to see whether they are able to generate more income compared to the costs incurred in penetrating the markets and try to move into the semi-urban and smaller urban market. While many smaller AMCs will protest at not being offered the pie, the dessert is only available to those who are willing to put in that extra effort to go beyond the low hanging fruit offered by large cities.

The third decision with respect to expense ratio of mutual fund AMC is also a good move. Till now, the expenses an AMC charged and could seek re-imbursement from the fund were capped. Not only that, SEBI prescribed how the expenses would have sub-caps. By making expenses fungible, SEBI has removed an area of pointless over-regulation within the overall regulation of capping of expenses. In other words, the AMC can charge any amount of expense to the mutual fund for managing its portfolio so long as it is within the overall cap prescribed by SEBI.

Fourthly, besides increasing the expense caps, SEBI has now mandated that where an investor is charged an exit load (a fee, usually on an early sale of the unit by an investor, say within one year of purchase) the exit load is credited back to the fund scheme (meaning other longer term investors) instead of it going to the AMC. This is clearly an investor friendly move which will insure that distributors who make investors pointlessly churn by buying and selling mutual fund units would not indirectly be incentivised for committing fraud on the investors (SEBI regulations term churning as fraudulent). Till now, every time a distributor made an investor sell prematurely, an exit load went to the AMC which in turn had more money to pass on to the distributor, thus incentivising illegal behaviour.  The incentive now goes away and short term investors will be penalised for the benefit of the longer term investors. A desirable re-alignment of regulations.

Fifth, it was decided that all new investors will be subjected to single expense structure under a single plan. However, where an investor came directly without the help of a distributor, the fund is expected to have a separate plan for direct investments, with a lower expense ratio. Since a fair part of the AMC fees is in turn paid out to distributors, where this commission is not paid to a distributor because the investor came directly, the benefit should not accrue to all unit-holders but only to those who came in directly. This is a fair segregation of plans, though it may be a bit challenging creating two mirror plans. One with a higher, another with lower expenses.

There are some  other changes, like permission to invest upto Rs. 20,000 in cash and without a PAN card, passing on of the service tax burden to  investors like in any other industry, clawback of compensation where non top-tier city investment is redeemed within one year (or reversing compensation where small town transactions are not genuine) . In the longer run, SEBI will also push for setting up a self regulatory body which will regulate the community of distributors of mutual fund units and also evolve a long term policy on regulation of mutual funds including enhancing financial inclusion, better tax treatment etc.

Overall, despite criticism from both sides, that SEBI has not done enough to compensate distributors and others saying it has gone too far and has hurt investors, SEBI has probably played a fair Aristotelian middle path. This can be deduced, perhaps humorously, from the fact that both criticisms have been of equal decibel levels.

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