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Ill-advised moves from SEBI

SEBI is turning fund investors' account statement into a pitch for direct plans of mutual funds. This is not a good idea

Ill-advised moves from SEBI

Last week, the markets regulator made a number of significant regulatory changes that will have a deep impact on the way mutual funds are sold. It's quite likely that these changes will eventually drive small, independent fund distributors out of business. Even though this is not the goal (at least, it's not the stated goal) of these changes, these regulations will make the operating environment even more distinctly hostile to such businesses. By elimination, they will work to the advantage of larger, corporate entities like banks.

The big change that SEBI has made is that the commission paid by the fund company to a distributor will be clearly mentioned in the account statement that the customer will get. Not just that, the account statement will also mention the expense ratio of both the regular and the direct plans of the scheme that the investor has invested in. The regular plan of a scheme is the one sold by distributors, while the direct plan is sold directly by the fund company to the investor. The two have identical underlying investments, but since fund companies' expenses are lower in direct plan (they don't have to pay commissions), the returns to the investors are somewhat higher.

In effect, SEBI has turned the customer's account statement into a marketing pitch for switching from regular funds to direct funds. The statement will effectively say to the customer, "Look here, your distributor is taking away this much commission from your money. If you invest in the direct plan of the same fund, then you will make this much extra." It's pretty clear that the regulator wants investors to abandon distributors and switch to direct funds. The new format for the account statement all but says so. It so happens that while direct plans have higher returns, they are a viable means of investment only for knowledgeable and experienced investors. Almost by definition, direct plans cannot lead to an expansion of the market, which requires the sales push that the distributor provides. SEBI's new push for direct will create a situation whereby distributors bring in new customers but as soon as customers turn profitable, they switch to direct.

The alternative model that SEBI has been pitching for is that of a financial advisor. Advisors can be paid only by investors, not by fund companies. The idea is that investors will pay a fee to the advisor and then buy direct plans based on the advice. However, this model is completely uneconomic for the small investor or the advisor serving him. It also runs counter to the culture of starting to pay for services that used to be free. It's clear that SEBI wants the fund distribution business to shut down. However, to go about it in this roundabout way, of squeezing small businesses till they shut down is really not the way a regulator should act. Instead, it should explicitly announce that distributors must switch to the advisor model and those who cannot should shut down their business. That's what the regulator's actions amount to, anyway.

Another unpleasant side-effect of these changes will be that it will further tilt the scales in favour of banks' fund distribution and advisory businesses. The reason is that while in theory, the rules apply equally to the small independent advisor and the banks, larger business handle any adversity better. Banks have captive banking customers and their cost and effort for acquiring and keeping customers is amortised over multiple businesses. We have seen this play out over the last several years over many rounds of incremental changes that SEBI has implemented. The tragic part is that all these changes were made to curb mis-selling, when in fact banks have inevitably been the biggest culprits.

Another problem here is that these changes will again widen the regulatory arbitrage between mutual funds and insurance. Can you imagine what would happen if insurance commissions are revealed as such to customers? The insurance industry would pretty much have to shut down!

All in all, these changes will have a negative role in the expansion of mutual fund investing, as well as the quality and quantity of services available to the small and beginning investors.

Click here to read a further comment on this issue from Dhirendra Kumar.