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The threat of innovation

The personal finance industry is constantly trying to innovate harder. Can investors deal with this threat?

The threat of innovation

Just yesterday, I read an article about an extremely thin card data skimmer that has increasingly been found in ATMs worldwide. The device is about 0.2 mm thick and can be installed in an ATM by a criminal by just inserting it as they would insert a card. Later, whenever anyone inserts a card in that ATM, it reads and stores the card data and the PIN. Unsuspecting customers insert their cards into such ATMs, and soon a large amount of money disappears from their bank accounts. Thankfully, this works only on magnetic strip cards. You should google 'ultra-thin ATM card skimmers' and see the photographs of this device. Even if one knows nothing about electronics, it's clear that the device has a highly innovative design and construction. It's the pinnacle of innovation in its field.

So what do you feel when you read the word 'innovation?' Is innovation a good thing or a bad thing? All dictionary definitions of the word just say it's something new, not good or bad. As a personal finance specialist, I have been reading news about innovations in this field for a long time, and by now, I react to them pretty much as I react to the innovation that has gone into the design and construction of the ATM card skimmer. The underlying goals of the innovators are pretty similar.

When you read news about the financial industry, you often come across something that the industry wants to be done in terms of regulatory changes and the only reason given for the change is that it will 'promote innovation' or that some other regulation should be modified or removed because it's holding back innovation. It's always implied that innovation is for good, and the mere usage of the word acts like a blessing that makes the changes desirable.

The reality is quite different. A prime example is the sudden, strong focus on passive funds in the mutual fund industry. This is supposed to be a great innovation in recent years and months. That's quite true, except that it's an innovation whose purpose seems to be to get around the limit that SEBI had put on the types of funds that a mutual fund company can launch. What's more, as always, it remains much easier to sell new funds than to build up a set of regular investors in older, established funds. Under SEBI's new fund categorisation system, more than one fund cannot be launched in the core categories, so the fringe, specialised categories are now seeing this 'innovation' since there's been a hard limit on the number of funds that each AMC can launch in the mainstream fund categories like large-cap equity, mid-cap equity and so on. However, passive funds are a loophole, and as it happens in such cases, the loophole is now the main gateway. So what we have instead is a fast-growing zoo of specialised passive funds. The stock exchanges will happily create as many indexes as AMCs want if they are paid what they want.

One aspect of this problem is that the responsibility of choosing which fund to invest in and how much weightage to give to each is now yours. With active funds, you had too much choice to deal with. To solve the problem, there's even more choice now! Of course, we also have a lot of intermediaries who will solve this problem for you and tell you which passive fund to buy and which to sell, how to create your portfolio, etc. Mutual funds are supposed to be a solution provider, but this transforms them into just a raw material supplier. You must create the solution yourself or pay another entity to create it. But that was not the deal, to begin with!

It's essential to go back to the main point. Who benefits from this spate of innovation around index funds? The investor's interests are served by having a small number of easily understandable funds that could be easily connected to personal financial goals. That sounds like real innovation.

Suggested read: A spate of (non) innovation

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