Auction-based procurement for fund managers is working well

A key development that has been taking place in India is the translation of the idea of auction-based procurement of fund managers into reality. Mainstream finance practitioners do not like to bid in auctions focusing on fees and expenses; it is argued that if you pay peanuts you will get monkeys. But the finance research literature has supported this kind of quest, emphasising low-cost passive management as the investment strategy of choice when dealing with liquid securities.

This idea was first proposed in India by the Project OASIS committee (who, in turn, got it from Estelle James). Now we have three success stories of such bidding:

Coal Mines Provident Fund, March 2007

1 basis point. This was 5x cheaper than the erstwhile arrangement.

New Pension System, 27 November 2007

3-5 basis points.

EPFO, 29 July 2008

0.63-1 basis points. Note that the erstwhile monopoly - SBI - was not the lowest bidder by far. EPFO has given assets to fund managers based on the strength of their bids.

Gautam Chikermane has a good piece in Hindustan Times sketching these events and their larger implications for pension reform. Also see an optimistic editorial in Indian Express.

There has been a certain amount of criticism of the procurement proces. See this gloomy edit in Financial Express, the story from Shaji Vikraman in Economic Times, and this story by Vikas Dhoot in Financial Express. I am obviously not aware of the full facts. It is true that the Ministry of Labour and EPFO are relatively inexperienced with such procurement. They face a hostile environment in the Central Board of Trustees. Despite these constraints, by and large, in my opinion, the outcome was a good one. I don't share the perspective of these critics.

When the Project OASIS report came out, many finance practitioners claimed that this report was out of touch in reality when talking about rock bottom prices for fund management using auctions. Now we have three auctions in hand, and it's safe to say that the fair price for wholesale fund management in India is atmost 5 basis points. While we don't yet have economies of scale in Indian fund management, we do have lower wages, which is giving us world-class prices even though the scale economies are not like those seen internationally. I believe that in a few years, the thumb-rule in India will be "the fair price for wholesale fund management is atmost 2 basis points" owing to bulking up with economies of scale. To help you fix ideas, an AUM fee of 2 basis points on an AUM of Rs.10,000 crore is Rs.2 crore a year which is about all it costs to run passive portfolios.

While on this subject, do see the `Wholesale Asset Management Companies' proposal of the Percy Mistry report (para 56-58, page 202 onwards).

If you are an individual investor using mutual funds or insurance companies, you should be weeping about the prices that you are paying. For a personal investing perspective, see this. From the viewpoint of the economy, this underlines the cost-effectiveness of a market-dominated financial system: it is able to link up wholesale liabilities into assets while suffering roughly zero friction.