Entry loads, exit investors

The Indian stock market today is moribund. The initial public offering (IPO) market is almost dead. In the 12 months ended March 31, 2012, just nine new equity fund offers were launched — the lowest for any 12-month period since March 2003. Money is flowing out of mutual funds while savings in the banks are swelling.

Among the factors that deter retail investors from putting money into the market are: rampant market manipulation; consent orders by the market regulator that let off some culprits easily; poor performance of 40 per cent of the mutual fund schemes; ingenious mis-selling; and a lethargic complaint redressal system. Under successive chairmen, the Securities and Exchange Board of India (Sebi) has not only failed to address these issues, but it has also made things worse by a patchwork of measures.
Last week, concerned that retail investors’ money is not exactly being channelled into mutual funds, the finance ministry apparently directed Sebi to consider bringing back “entry load”. In August 2009, Sebi had banned entry load, which is a charge fund companies imposed on initial investments made by mutual fund investors. Funds used the entry load to offer incentives to distributors and abused it to write off all kinds of marketing and promotional expenses. In some cases during the bull market of 2006, entry loads were as high as seven per cent. This meant that after putting in Rs 10 in a fund, on day one, your net asset value was down to Rs 9.30.

Sebi cracked down on these practices in 2007, and then banned entry loads altogether – without much discussion – in August 2009. Asset management companies, or AMCs, could pay the distributors out of their own pockets if they wished to. The effect of this was to empower larger distributors like banks that could bargain up their incentives from AMCs and alienate smaller distributors, sometimes more ethical than banks. Many have been exiting the business of selling mutual funds. In February last year, when U K Sinha took over as Sebi chief, he made an attempt to incentivise distributors. The move was so frivolous that it left all stakeholders cold.

Along with this, many distributors have shifted to selling insurance products as investments — usually a poor option for savers. Insurance companies currently pay large first-year commissions. Most investors ended up buying insurance, gold and real estate that was pushed at them or preferred to keep the money in the bank. Apart from a few exceptions, despondent fund companies saw declining sales and even the exit of Fidelity, one the largest global names in the fund business.

Will bringing back entry loads change anything? It may well coincide with other reform measures, a strong market rally, suddenly higher returns from mutual funds, and, therefore, serve as proof that all that was needed to bring back investors to mutual funds’ fold was incentives for distributors. If this happens, it would be coincidental and tragic. The finance ministry must go beyond the issue of entry loads and look at the whole terrain of financial products holistically. It should approach it from the point of view of consumers, savers and investors and get answers to the following questions, just as a start.

• Why should two competing products, unit-linked insurance plans and equity mutual funds, have different sales incentives and different sales processes — one able to use celebrities and the other, not?
 
• Why should the Reserve Bank of India take a hands-off approach to mis-selling of both mutual funds and insurance by banks — the largest source of distress for investors? 

• Why should Sebi adopt a hands-off approach to approving mutual fund schemes?
 
• Why should Sebi not insist on banning fund houses from launching new funds unless a majority of their funds have been able to cross a few predetermined benchmarks?
 
• Why is there no correlation between fund performance and fund corpus?

It is the job of the finance ministry’s Department of Financial Services to step in and get answers to these questions because none of the three key regulators are interested in looking beyond their domain. Indeed, left to them, they would fight among themselves or, worse still, get defensive about the worst practices of the companies they regulate. And leaving mutual funds, insurance companies and stockbrokers to themselves would, of course, mean throwing savers to the wolves.

We know how, during the bull run of 2003-2007, stockbrokers, companies issuing new shares, and fund companies and their distributors ripped off investors. Indeed, funds rarely sell their funds on the basis of performance; they depend on either advertisements or bribing distributors to push their products. Consider the fund industry’s actions in the months after Sebi abolished entry load: it was blowing money on flying distributors to expensive junkets. One of the top funds took its top 50 distributors to Italy for four days. Another one took some of its distributors to Kashmir. HSBC took them to Kerala for a long weekend. Ironically, since there were only 20 active funds and only 50 large distributors, all the fund companies were trying to do the same — the distributors were sick and tired of such frequent junkets.

The investor population in India has been declining relative to rising prosperity, and much of this is due to half-baked regulatory changes. Luring people with funny schemes named after Rajiv Gandhi or removing entry loads won’t help. When will the finance ministry start seeing things from the savers’ perspective?
 

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