Pioneering Change

A series of regulatory changes over the last year have transformed both fund investing and the fund business in India. In an exclusive interview, KN Vaidyanathan, Executive Director, Securities and Exchange Board of India, emphasises that the sole driving force is the interest of the investor.

Over the past one year, SEBI has brought about numerous changes in the mutual fund industry, both big and small. Are these changes part of a vision of what this industry should look like, say, 5 years down the road? Or is SEBI tackling problems as they see it? Can you tell us where you are headed?
Let me make two points.

First of all, this is not like investment banking where the action is big bang. This is about impacts and changes which are persistent, day after day.

Secondly, I am a big fan of cricket and a big believer in LBW; technology in LBW. I think if anyone applies the LBW logic which is the hawk eyed projector, you can actually see where we are going. Whatever we are doing, if you want to onward project where it is heading, it will be pretty obvious.

So combine these two tenets; we are not looking at a big bang but want to make a series of incremental changes. Then it will not be too difficult to figure out where we are heading.

What is the long-term vision that you are working towards?
The vision of the mutual fund department within SEBI will be a sub-set of the vision of SEBI. So the question is: Where is SEBI heading as a regulator?

I think over the past few years you would have noticed a shift in SEBI's approach. The first 15 years of SEBI was spent on creating the framework, laying down the rules and regulations. Since early 2008, SEBI has become much more direct and forthright. To being a lot more investor centric in its actions - its rules and regulations. The mutual fund department is going to follow the same path - be a lot more direct, a lot more forthright and investor centric.

So what would you say are SEBI's goals with regard to the fund industry?
The long term goals are Investor Protection and Responsible Intermediation.
We will achieve investor protection through a combination of regulations and education awareness. Our goal is to bring about an informed investor.

What do I mean by responsible intermediation? The sustainable business model in any consumer business is built on the premise of appropriateness and affordability of the products. Responsible intermediation should strive to ensure that the consumer, before he is sold a product, is validated for his appropriateness and affordability for that product. That, in a way, captures all the components that intermediation tries to do in mutual fund distribution. We would like to see far more responsible intermediation on part of the distributors and AMCs. The series of measures that have been implemented are all about tightening certain aspects to make sure the investor gets the chance to be better informed. Let me give you an example. One of the measures we undertook was to ensure that the Key Information Memorandum (KIM) was given a lot more prominence. Hitherto, there was a fairly active exchange between the mutual fund and SEBI through what was called the Scheme Information Document (SID) and Standard Additional Information (SAI). Now the mutual fund and SEBI have extensive conversations to and fro on that document which the investor is clueless about. But our role is to endeavour that this output will enable the investor to take a more informed decision.

So we said that the final cut of the SID will be in public domain since it incorporates all the changes, modifications and clarifications on questions raised during the regulatory review process. And we also said that the KIM should come to us, because that is the document in circulation. So SEBI wants to see what eventually goes to the investor. It has to go through the regulatory discipline and vetting process.

One of the good things about the Industrial Revolution is that it taught the world the benefits of standardisation. So if you have KIM each as a work of art, a consumer will find it extremely difficult to compare A with B. Now we want the investor to see the documents as reasonably comparable. So we created a broad structure for KIM because it is not our aim to micromanage mutual funds. But it is important that we put in place a framework whereby it helps the customer take more informed decisions.

What is a mutual fund at the end of the day? An individual needs help to manage his money so he will come to a professional money manager and hand over his money. He needs to know what the money manager will do with his money - and that is what KIM will tell him. What is the investment objective? What investment strategy would be utilised to achieve that objective? What asset allocation will be employed that goes with the investment strategy? In that asset allocation are inherent risk factors. How does the fund manager hope to mitigate those risk factors? Then there is the benchmark. There has to be one so that the scheme can be evaluated. To me these are basic questions that anyone will ask before turning in their money.

How does this fund differ from other funds in the AMC's stable? There are fund houses with 15 to 20 equity funds. Of course, large part is the consequence of happenings of the past, thanks to the NFO craze.

But they were approved by SEBI.
SEBI issues final observations on an NFO document because SEBI never micromanages. We want to make sure that the quality of disclosures made is better to help the investor. That is where we are heading. Our goal is to ensure that the mutual fund is disclosing ample information about the product and itself to help the investor make an informed decision. Does the KIM reasonably answer the questions I mentioned? There is a minimum amount of information we would like disclosed. We lay the minimum standard. If there are players who want to adopt higher standards, they are free to do so.

To summarise what drives us?
One, investor centric through investor protection, combination of regulation and awareness creation so that there is a more informed investor.

Two, responsible intermediation.

Three, be proactive and implement rules and regulations with ample room to allow the industry to work and which, at no point in time, compromise on the primary objective of investor protection.

We would like to see different types of products coming in. We would like to see the market broadening. But we are not in a great hurry to push any of these as we ruthlessly push investor protection and responsible intermediation measures. But if there are players who want to take the lead, we will certainly review those.

Can you tell us more of what you mean by responsible intermediation? Responsible intermediation to some realistic observers of the financial services industry would sound like an oxymoron.
It's unfortunate but you are bang on dollar. To a lot of people in this country, it is very unfortunate that mis-selling seems to be the only form of selling.

Selling driven by immediate profit. It may not be mis-selling if that is what the regulations permit.
You have to go beyond that. It's not just about regulation. We want people to view it not limited to the context of regulation. We want people to understand that this makes good long-term business sense. You are building a business. You are not building a business for today but for the long term. Till people embrace that, there will be the cynical view that responsible intermediation is an oxymoron.

Why do people enter the asset management business? What is appealing about it? It's a tough business. It's a boring business. There is no glamour to the business like sell side investment banking is. But it attracts a valuation coming from what is called annuity. I am only talking economics, not regulation. It's one of the few businesses in the world where on the first day of a financial year the P&L does not start at zero. And that is what you are getting valuation for. The moment you say annuity, it is evaluated by the market on two counts; stability and quality. The same two counts that you will evaluate, say, an infotech company in India; the stability of its earnings and the quality of its earnings. Or, for that matter, a consumer product company in India. People evaluate income on these two counts.
An asset management business is naturally geared to provide that annuity and the two components are stability and quality. Therefore, embedded in your business model is the long term and long-term valuation will come out of stability and quality of revenues.
When I say quality of revenues it really means how you have earned it; whether through the inherent nature of the business, by adding value and therefore your pricing power will remain, or have you earned it by other means. So products or services which have taken advantage of some short-term opportunity never score high on quality of earnings.
Now if you come back to stability and quality, intrinsic to that is long term. Therefore, long-term customer. So the business model must be built to achieve this. Once again I remind you, I am not talking of regulation but on the economics of a business model. This is not a transaction where I do business once and forget about you. Investment banking, the brokerage business is very transaction driven. Asset management is relationship driven. The asset manager is a daily wage earner. If your money is with him today, he will accrue fees today. The only way he can accrue fees is by making you stay longer and longer.

So you are attempting to drive a change in the very business model.
Look at blue-blooded global players. They will score high on the two counts I have mentioned. Look at the Indian asset management industry where 50 per cent of them have not made money. And we are not just talking one year, but four years or more. Fifty five per cent of the P&L on the expense side, for asset management companies, is marketing costs which are paid to distributors. Typically, in an asset management business, people cost is the highest. So the business model built is not based on the fundamental principles of the asset management business. But we also have here in India some fund houses who have both a long term track record of performance and the AMCs are profitable. Hence responsible intermediation is logical to some of the principles of asset management value creation.

The cost of raising money in the mutual fund industry had gone up to 4 per cent in 2008. What was covered as entry load, even then, was 2 per cent. So the balance 2 per cent was out of pocket. The earnings for that period was 10 bps of AUM. Which means that fund houses were giving 20x one-year earnings to get business. On the flip side, the longevity of the asset was 1.1 year. That is flawed modelling. Why did this happen? Because somewhere in the 2000's, one fund house was sold to another at 6.5 per cent of AUM. Therefore everyone thought that it did not matter whether I have stable or quality revenue, but if I have high AUM it will attract a great valuation. To me this is déjà vu. Because the first few dot com companies got the same valuation and the rest thought therefore they too would. Eventually, money is made by blood, sweat and tears. So that same valuation which had gone up to 6.5 per cent I am now seeing it at under-2 per cent. And it will go further south until we dramatically change the two components of stability and quality.

So if you run a business driven by expected valuation, which is very short term, and, therefore, adopt measures which seem to support it, when that imperfection is taken off, it's like the tide flowing back to reveal who is swimming naked. We saw hype in several other areas like real estate and the dot com boom. In the history of global capital markets, hype subsides and reality sets in.

So SEBI regulation will be the driving force for AMCs to revisit their business model....
I think it is very important that there is a review of the business model. The regulatory aspect is just one component of that. My encouragement to every AMC in India is that they take a hard look at the business model. It's a beautiful business model from the valuation stand point provided you focus on stability and quality of income. And that is built over the long term. So when you rebuilt that, yes regulatory change is important but is not the only aspect.

The AMC and the regulator must have a common goal. SEBI's goal is investor protection, the AMC goal must be investor retention. Both are focussed on the same end - consumer. So there is clear alignment.

In the course of these adjustments, there will be wrenching changes. Are the short-term impacts a concern for the regulator? For instance, it's widely believed that the entry load abolition has hit the smaller IFA adversely and the larger distributors will have a disproportionate share of the business. And this is a consequence of SEBI regulations. How would you react to this point of view?
If you had asked me this question around seven months ago when I was still very new at SEBI, I would have possibly gotten agitated. That is not the case now. My learning, and I am still learning, is that what you see is not what you get.

If you look at the service that is delivered to the small IFA, then their concern for the small IFA is exposed. This industry relies on two service providers. In the secondary market there have been tremendous changes in the delivery model and use of technology. The fund industry still has reasonably archaic delivery models. Let's take the example of an IFA who has 10 customers invested in three funds. So he will have to go through 30 pieces of paper. So when such arguments are made about the small distributor, I believe these are convenient shoulders from which they are firing because it has a nice little wrapper of 'caring for small investors'. Lip service statement of concern does not strike oil.

I gave you the example of the cost of raising money being 4 per cent. It's much lower from an IFA and higher from a ND, while the bank segment was the highest. So if there is so much concern about IFAs, the model should have been different. So not often what they say is what they mean. And I am not so convinced about their great concern for the IFAs. I as an investor should have the freedom to change from Distributor A to Distributor B. Yet the entire industry went through this in the past few years putting all sorts of restrictions. Finally the regulator had to step in and say this is anti-investor. The investor must have the freedom to move. So take that purported concern for small IFAs with a bag of salt.

There is no denying that a number of the smaller distributors are moving out of the business altogether....
We are well aware that if there is no entry load, it will hit distributors whose sustenance was dependent on the entry load. In 1992, when brokers had to get registered there was huge resistance and they actually went on strike. In that one stroke, I believe they sowed the seeds for creation of the National Stock Exchange. In the early Nineties, the cost of secondary market transactions used to be 2.5 per cent. And a nice little club thought it was their birthright to earn that. Today you can transact at between 10-20 paise. So while the revenue model has come down to 1/10th, volumes have gone up 10,000x. There is a lesson in this. To capture the Indian consumer there is a price value point. If you get that price value point, volumes happen. So 2.5 per cent was not the price value point. People affected by the new model had to take a cold hard look at their business model.

Entry load is a closed chapter, so no point hoping that it will change. Come to terms with it. The next logical step would be to look at where value can be provided. What is the service that I can offer for which I can get reasonably paid? Either paid by the fund house if I am purely a commission agent or by the investor if I am able to provide advice. They need to take a hard look at their business model and see how they can re-orient themselves. In the process, there will be some big winners and some losers.

Definitely. Some businesses will not survive.
That is Darwin's theory. But nothing will happen by wishing. It will happen by very deliberate measures. In 1994 there was a feeling that since foreign brokers were allowed in, Indian brokers would be wiped out. Now 16 years later that is not the reality. In fact the foreign broker presence in the retail business is miniscule. But the Indian brokers reinvented their business model. And adapted to the change in environment to reduce costs, lower fees and increase volumes. It took an environmental change to get re-oriented. So my appeal to all in this business is to come to terms with reality. Assess your strengths, your value proposition and decide whether you want to be investor centric or manufacturer centric. Like other parts of the capital market, technology will enter in a reasonable way.

Right now there is an imbalance. Those with deeper pockets are at an advantage during the period of transition while others are struggling.
History repeats itself. If you miss it, the first time it will be a tragedy, the second time a farce. There were jobbers way back in 1992 who went out of business. But you don't stop the big picture change because it may be detrimental to a few constituents. The noisy one is the minority, the silent one is the majority. The majority are the investors, who have been silent. So someone has to worry about them. Think about e-broking as against the traditional broking method. Can we stop technology from coming in and making the system more efficient? But advice, good quality counsel, financial planning and asset allocation are personalised services.

A grouse amongst the AMCs and distributors is that the timing of scrapping the entry load hurt, soon after the crisis of 2008. And the view is also that the time given to adjust to the new regime was way too short.
That is incorrect. The decision was made on June 18 at SEBI's board meeting and the rules were put out by the end of the month. It got implement on August 1. That was one month. So you say 'way too short' for what? What is it that three more months would do other than charge a higher entry load? What would those three months have done for the investor? And this discussion was in public domain from December 2008. Look at July 2009 data. It showed the highest gross sales in two years. It also had the highest cost of raising money. It was like an 'end of season' sale. Should we have permitted that over three more months? I cannot see any merit in that argument.

You must understand the pain point of a stakeholder. How do we deal with an October 2008 crisis? By ensuring that the product is not projected as what it is not. The liquid plus product was projected as a stable NAV product. Far from it. So we changed the valuation model and gave the industry a few months to adapt to it because there is an investor interest in that. Where I deal with market forces and need to approach it with caution, I will give time. We have just put out an entire paper on derivatives and even dealt with the concept of disclosure of positions too.

In the case of entry loads, give me one good reason why we should have permitted it for one extra day.

The crucial factor for success is investor education. It will work well if the investor at the end of the day knows who is giving him a better deal and who is not. How do you see this progressing?
The mission is investor protection. Investor education is a means to it. For us as a regulator, investor education means implementing measures to help the investor make a more informed decision. Investor education is interpreted for a lot of people as conducting a seminar. That is one way, but not the only way. And certainly not the most effective way or the 21th century model. A lot can be done without running a physical seminar. We have to keep steadfast on our goal which is to get the investor to be more informed.

Take the case of bank deposits, which rarely have salesmen. But the highest savings allocation is to bank deposits. The consumer is telling you something here. Look at it as against commissions and entry loads and the potential for mis-selling. The answer is stark and staring at you. We want to make sure that whatever hits the investor has gone through regulatory vetting. And we will keep tightening those to ensure that what reaches the investor is better quality. Look at the practice of some fund houses to pay dividends out of the balance sheet. It's flawed accounting. Dividend is paid out of P&L. Obviously there will be long-winded explanations by those affected by our directive. But if you do not clutter your mind with this irrelevant data and go to the crux of what is 'dividend' - which is distribution of earnings - then earnings come from P&L account. Earnings do not happen in the balance sheet. This is not about regulatory change, it is about tightening. SEBI knew that this was an opportunity for mis-selling so plugged it through an accounting regulation. These matters are very elementary to the business.

In October 2008, the shorter duration funds were treated like surrogate banking products. In that if something went wrong, did the parent have deep enough pockets to take the hit. There were some product flaws too...........
I like the point you made, that they were being sold like surrogate bank deposits. This is the biggest disservice that we can do. All investment products are about a certain return potential for a certain level of risk. The unfortunate thing about then liquid, now liquid plus, products was that it was positioned at a risk level comparable to a bank deposit while promising a higher return. This is fundamentally flawed. If you tracked the NAV of liquid plus, the volatility was a like a dead man's heart beat. So we systematically addressed it. The assumption was that Day 2 NAV will never be less than Day 1 NAV. That was the premise. So the investor was lulled into a false sense of security. The day it is openly stated that Day 2 NAV can be potentially less than Day 1 NAV there will be an entire change in the investors' evaluation of the product.

The October 2008 crisis is not a failing of the mutual fund industry. It's important that everyone understands that. It was about a freeze on liquidity. If money does not move from A to B, no market exists. So there is no insurance available to protect against a repeat of the liquidity freeze of 2008. That crisis triggered a thinking which would otherwise not have come to the surface. It showed a mis-match between investors' risk appetite and return expectation because of the way this product was being managed. That mis-match stood out because the moment they suspected a potential risk, they wanted out. And the way out did not exist.

As much as people say that there is no debt market, I would credit the mutual fund industry with a debt intermediation process. Save and except 2008 which hit the world, I think Indian mutual funds still run a reasonable debt intermediation portfolio. Outside 2008, there has been no crisis. However, there was tightening required in the NAV policy which we addressed.

So in the big picture of debt intermediation, maturity transformation, mutual funds are doing well and can potentially do a lot more, specially in the retail area. And I hope they do. But we will keep tightening where there are shortcomings that could affect investors.

Is there a time frame within which SEBI and IRDA have to take a legal action to resolve the issues over ULIPs?
IRDA and SEBI have been directed to find a legally binding solution in an appropriate court. We are working together to find that resolution.

AMC: Asset Management Company / AUM: Assets Under Management / NFO: New Fund Offering / P&L: Profit & Loss Account / IFA: Independent Financial Advisor / ND: National Distributor / NAV: Net Asset Value / LBW: Leg Before Wicket, in the sport of cricket one of the ways in which a batsman can be dismissed / bps: basis points, 100 bps = 1%