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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