Suggestions for controlling cost of your investments

Ajay Shah has a post on combating fees and expenses of fund management  in his blog. He discusses in detail the steps being taken by SEBI and IRDA in making costs of investing more reasonable. He also has his suggestions  to consider when you want to build a portfolio for yourself.

One of the important problems afflicting Indian finance is the phenomenon of high fees and expenses charged for fund management services by financial firms.

There is something paradoxical going on here which I don't fully understand. In some situations, Indian customers are incredibly price sensitive. But when it comes to fund management, customers seem to be willing to tolerate very high charges, and accept astonishing levels of non-transparency.

Progress at SEBI

The mutual fund industry has been afflicted by fairly perverse phenomena. There is the inherent conflict of interest where the distributor takes money from the manufacturer while advising the investor. The distributors have a tremendous stranglehold on customers; there is a race to the bottom taking place where the mutual funds which squander the most customer money on the distributor gain market share. One symptom of the idiocy of what is going on is the bias in favour of churning (customer switching from one scheme to another since the distributor earns a fee at every fresh investment) and the bias in favour of `new fund offerings' at which point distributors make a killing.

SEBI embarked on an important initiative, proposing to force mutual funds to give customers a choice of buying mutual fund products directly – e.g. through the Internet – without going through the fees and expenses associated with distributors. I had blogged about the SEBI proposal in August 2007.

The industry tried hard to lobby against these proposals. Two weasel clauses that were proposed were : (a) Having separate no-load funds, as opposed to having all products available for direct distribution, and (b) By having `variable loads' where customers would be able to negotiate prices with the distributor.

SEBI has come through fairly well on this one. See this story by Sandeep Singh in Indian Express, SEBI's press release and circular.

Ajit Dayal pointed out to me that the practical implication of this effort has been greatly undermined by the requirement that the physical PAN card has to be verified before an online transaction takes place. In other words, the canonical online transaction – the ability for a stranger to be able to come up to the website of a financial firm and put in money – is infeasible. SEBI strongly needs to switch the sequencing around: Require the physical verification of the PAN card after the online transaction and not before.

Progress at IRDA

Gautam Bhardwaj of Invest India pointed out to me that as a country, the impact of SEBI's move is limited because it will merely push the distributors away from selling mutual funds to selling insurance products, where the most toxic distribution strategies are to be found. An across-markets perspective is required on the part of policy makers. As long as distributors / advisors are paid for transactions, there will be a bias in favour of churning, a bias in favour of selling products from AMCs that pay the highest fees, etc. As Gautam Chikermane has emphasised, this is a strong argument in favour of unified regulation, atleast for the purpose of all financial products sold to retail customers. While on this subject, see the proposal of a `Financial Product Safety Commission' in the US by Elizabeth Warren of Harvard Law Schoolop-ed version.

IRDA has also been making progress; it has started asking for more disclosure about how much money is actually invested. There are going to be some red faces when it is revealed that out of Rs.100 paid by a customer, only Rs.40 will get invested in the first year. Monika Halan describes the IRDA initiative as going from 20% transparency to 60% transparency. She emphasises that the burden on customers is the sum of fees and expenses, and when there is transparency on fees, it's easy for financial firms to switch to administrative charges. As many readers will recall, this ease of portraying marketing expenditures as either fees or expenses is the reason why the design work of the New Pension System (NPS) has long emphasised selection of pension fund managers (PFMs) based on an auction focused on one number: the sum-total of fees and expenses.

What is a customer to do?

When I write blog entries like this, I get a fair supply of email asking what should the customer do. Here are my suggestions:

  • There is a small group of products that I am comfortable with: there are index funds (both open-ended funds and ETFs) and there is Quantum Mutual Fund. I like the Nifty and Nifty junior ETFs from Benchmark Mutual Fund, which are the lowest-cost index funds around.
  • I would encourage customers to avoid the fund management products sold by insurance companies: Buy pure insurance products from insurance companies if you really need insurance, and avoid the bundling of fund management with insurance.
  • In all cases, I would encourage the customer to avoid distributors, be very conscious about the grand total fees and expenses being inflicted on you, and pay as little as you
    possibly can to financial firms. Fund management is a rare field where paying more generally gives you lower quality products.
  • Avoid all `New Fund Offerings' (NFOs); do not churn.
  • Become a customer of the New Pension System, which is phenomenally low cost, when you get the opportunity. The NPS has no NFOs, no innovative product development, no distributors, just honest down-to-earth low cost fund management.

The agency business of securities firms is fine

While these difficulties afflict the fund management industry, as a rough approximation, I think the securities firms are carrying no fat. Entry barriers are low, competition is brutal, fees and expenses are fully transparent, there is no shades of gray in judging whether the firm performed its job, there is no illusion of performance.

In absolute terms, the charges are high. As an example, see this story. However, as diagnosed in Box 2.8 (page 29) of the MIFC report, the bulk of this story is the array of transaction taxes that have been imposed by MOF and SEBI that are driving up the charges. Once these are stripped out, charges in India are not out of line.

A glance at the brokerage firms in the CMIE database shows some interesting facts. I focus on the performance of the aggregate industry, and juxtapose a bad year (2002-03) against a good one (2005-06):

Parameter

2002-03

2005-06

PAT / Net worth

11.27

23.03

PAT / Total assets

3.93

8.97

These profit numbers are the `normalised' values reported by CMIE, where the bulk of earnings management is stripped out using procedures that are consistently applied across firms and across time. The values reported above are not that different from the evolution seen for the universe of non-financial firms, which I use as a benchmark of performance under fairly competitive conditions.

 


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