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Thursday, February 02, 2006

What you pay for fund management in India

Modern finance, based on securities markets, is a great enterprise when compared with the old banking-oriented finance. As Merton Miller says, banking is a disaster-prone 19th century industry. Emphasising the securities markets avoids the periodic disasters with banks that seem to afflict most countries, particularly the countries which are unable to close down a weak bank before it's insolvent.

From this framework, there is much to like about mutual funds and `defined contribution' pensions: there is no leverage, all assets are marked to market every day, if a money manager goes bust it's easy to replace him with a new manager since customer assets are not comingled onto the money manager's balance sheet, and all losses are borne directly on the balance sheets of households.

The one bad thing with this happy picture is: the fees and expenses that customers suffer. I am unable to fully comprehend why, but customers simply do not seem to understand how damaging the fees and expenses of their fund manager are. For a normal product such as a refrigerator, paying more generally gets you a better product. But that isn't true for fund management, and customers just don't seem to see that.

Cellphone calling plans are plagued with an attempt to obfuscate customers and make it difficult to understand where you will get socked with charges. But atleast in the end, the customer of the cellphone clearly understands two things: He understands the call quality and he understands the number that he writes on a cheque every month. With fund management, these two things don't happen! The customer doesn't understand what "call quality" he is getting. And the customer doesn't know what number is on the cheque he is writing every month to the fund manager.

I believe there is a serious market failure taking place here. In India, the commission model has come to dominate, where agents sell fund products to customers and collect a fee. There is competition between finance companies and competition between insurance versus mutual funds, each trying to gain market share by giving the agent a bigger discount. One foreign bank has an internal target of obtaining 12% of the wealth out of each customer of theirs per year. This, in a country where the expected return on the equity index is probably 13%. The worst excesses of this kind are by the insurance companies. Of the Rs.60,000 crore that went into insurance companies in 2004, Rs.6,000 crore (or 10%) turned around and went back as kickback to agents! But the mutual funds are now determined to match the insurance companies in this racket. Recently, SBI Mutual Fund reached a new low by paying 7% to the agent. So when the customer puts in Rs.100, only Rs.93 gets invested.

Monika Halan has a good article on this problem in today's Indian Express. What can you do different at a personal level? One big thing that comes to mind is: Buy Exchange Traded Funds (ETFs) on the exchange screen. The only direct fee that you pay is brokerage, which is a competitive market and really cheap. You do need a tight bid-offer spread on the screen, but that's often available.

In the long run, will the situation get sorted out? Competition between agents could drive down their fees. Customers could wise up, start looking at fees and expenses, understand that when they write a check for Rs.10,000, the agent is getting Rs.700, and favour index funds sold over the net without commissions in the picture. But all this could take many decades. Can we do better? The design features of the New Pension System are focused on addressing some of these problems with the market for fund management products. You might find my paper on the Indian pension reforms useful.


  1. I think as far as fund management is concerned, there is also the issue of monitoring the fund manager's investment behaviour. It makes complete economic sense to tie the compensation of the manager to the performance of the fund (like how you would want the compensation of the CEO to be impacted by the performance of a company). But my interpretation of the reports of the huge churn of fund managers in India and the sky rocketing salaries that they now command, is that such an effective monitoring process is just not in place.
    Raghuram Rajajn discussed a possible solution to this on his last trip to India..Invest a portion of the manager's compensation in the very fund that he operates. Simply put, the manager would have an monthly SIP on his own fund. And if he leaves the AMC, don't give away the entire amount that he has invested. Leave about 50% of his corpus in the same fund and ensure that he can withdraw it in a phased manner over say a few years. This would then ensure that the manager retains a slightly long term perspective when he invests and is not carried away by the momentum of the market.

  2. Can a mutual fund survive without these fees and expenses? the very fact that they're widely used implies that they work and/or are an industry standard. Point is, caveat emptor. There are dirty tricks everywhere, not just here. The possible reason could be that the average investor trusts the agent and does not do his/her homework. If he/she did, no input from the agent would be necessary in choosing a fund. perhaps investor education might help? once that is in place, fees and expenses might come down cos they no longer work.

    I like the manager investing in his or her fund idea. I think the US MF longleaf actually prevents its employees from investing elsewhere.

  3. Aditya, I never implied that fees+expenses has to be 0. Just that the `ordinary market process', which normally drives down prices through competition, doesn't work very well in this business. A simple challenge. Talk to 10 people around you who are customers of mutual funds. Ask them how much they are paying as fees+expenses. In contrast, ask them the price of (say) a Maruti Zen or what they are paying every month for their phone bill.

    What seems to be happening is that customers just do not understand that they are writing a cheque to the mutual fund manager every month for fees and expenses. If customers do not perceive this payment, then the market will malfunction (as it is presently doing).

  4. on a more macro scale,
    i think it was tobin who said that "from a developmental perspective, the best brains in the world should not enter the financial sector."

    but to whom do all the skyscraper-offices belong? hsbc? icici? FACT: it_is_the_financial_Sector which offers the highest salaries today.

    now the question to be asked is, if in the longer run an indirect approach towards development (via finance) is better that the direct one.. (via manuf.)...


  5. This is true.Fund mangers'behaviour differs.SBI Tax gain is managed by an aggressive manager with orientation towards growth and gain.Other SBI funds are m,anaged by lethargic managers who are towing deleterious lines.
    HDFC funds is minting on fees and commission.Further mutual fundagents like Anagram/Geogit/infoline etc charge heavily and recommend funds which give more brokerage or commission.

  6. Best think could be the fund managers should start publishing a monthly report to its fund customer with breakdown of the fund holdings and returns of each holings. Clients have all rights to know this information.
    Is that happening in case of all Fund Managers and agents? Not sure!


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