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Tuesday, July 17, 2018

Unintended consequences

The Securities and Exchange Board of India’s suggestion of giving mutual fund investors the choice to negotiate...

Written by Jaideep Lunial | Published: March 2, 2009 11:10:19 pm

The Securities and Exchange Board of India’s (Sebi) suggestion of giving mutual fund investors the choice to negotiate the entry load with the mutual fund distributor has stirred up a hornet’s nest within the industry. Though there were enough signs that such a proposal was in the works,its announcement has caught the mutual fund distribution community napping. This proposal comes a year after Sebi’s decision to introduce ‘no-load’ funds,wherein no entry load is charged from the customer if he submits his mutual fund application directly at a branch office of the fund house,or via its website. While Sebi’s latest proposal is laudable,there is a need to examine its implications in-depth and whether it will help mutual funds achieve greater penetration.

Low financial literacy. Sebi’s proposal may not have the desired effect of lowering the entry load for investors because of the low level of financial literacy in the country. Due to this,a vast majority of buyers may fall prey to distributors’ sales pitch and end up paying the maximum permissible load of 6 per cent,which is nearly thrice the current maximum load of 2.25 per cent.

Direct payment to brokers. The second part contemplating a system where the client pays the brokerage to the distributor directly has even more serious implications. The main purported beneficiary of Sebi’s proposal will be the common investor. But the latter may be investing an amount as low as Rs 500 a month through SIP. That translates into a brokerage of around Rs 10 a month at the current rate of 2.25 per cent,or Rs 30 a month at the highest permissible load of 6 per cent. Will collecting such a small amount be financially feasible for the distributor? My fear is that distributors will begin to avoid small investors and focus on a select group of big investors. Instead of improving the reach of the product and the quality of service rendered to small investors,this proposal might end up having the opposite effect.

MFs versus Ulips

A very similar product to mutual funds is the unit-linked insurance plan (Ulip),which is governed by the Insurance Regulatory Development Authority (IRDA). Today many Ulips have only a small element of insurance and are quite investment oriented. An investor can either invest in a mutual fund or a Ulip to achieve almost the same goals. And here we have two contrasting approaches of regulators dealing with similar issues. On the one hand,Sebi has allowed no-load funds. On the other hand,sellers of Ulips receive a payout as high as 50-60 per cent of the investor’s initial investment. IRDA is aware of the pitfalls of such a high level of commission. It has recently stipulated that a Ulip seller must present a detailed illustration,mentioning all the charges,to the investor and get it signed by him.

The fact of the matter is that financial illiteracy is very high in the country and even the most educated of investors fall victim to mis-selling wherein the distributor,after pitching for the sale of a mutual fund,puts the client’s money in a Ulip. That this is actually happening is supported by data: funds collected by Ulips are almost five-six times the amount collected by equity mutual funds. This is result of the huge disparity in incentives for selling a Ulip vis-à-vis selling a mutual fund. This disparity in incentives has resulted in a huge workforce of insurance advisors who outnumber mutual fund distributors almost 50:1. For this reason,the insurance industry has a much deeper penetration in the country than mutual funds.

This is why Sebi’s latest proposal may boomerang,unless investors become financially literate (something that is not going to happen overnight),or unless Ulips and mutual funds are brought under a uniform set of rules (which is again not possible currently since the regulators are different). Till all this happens,every move by Sebi to marginalise mutual fund distributors will push them towards the high-remuneration insurance industry. Remember that given the low level of financial literacy in the country,a lot of products get sold because they are pushed (or actively sold) by distributors and agents. Unless distributors are offered the right incentives,they may bypass mutual funds altogether.

The author is a Certified Financial Planner and director of Wealth Gyan.

These views are personal.

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