Combating fees and expenses in fund management

One of the important problems afflicting Indian finance is the phenomenon of high fees and expenses charged for fund management services by financial firms.

There is something paradoxical going on here which I don't fully understand. In some situations, Indian customers are incredibly price sensitive. But when it comes to fund management, customers seem to be willing to tolerate very high charges, and accept astonishing levels of non-transparency.

Progress at SEBI

The mutual fund industry has been afflicted by fairly perverse phenomena. There is the inherent conflict of interest where the distributor takes money from the manufacturer while advising the investor. The distributors have a tremendous stranglehold on customers; there is a race to the bottom taking place where the mutual funds which squander the most customer money on the distributor gain market share. One symptom of the idiocy of what is going on is the bias in favour of churning (customer switching from one scheme to another since the distributor earns a fee at every fresh investment) and the bias in favour of `new fund offerings' at which point distributors make a killing.

SEBI embarked on an important initiative, proposing to force mutual funds to give customers a choice of buying mutual fund products directly - e.g. through the Internet - without going through the fees and expenses associated with distributors. I had blogged about the SEBI proposal in August 2007.

The industry tried hard to lobby against these proposals. Two weasel clauses that were proposed were : (a) Having separate no-load funds, as opposed to having all products available for direct distribution, and (b) By having `variable loads' where customers would be able to negotiate prices with the distributor.

SEBI has come through fairly well on this one. See this story by Sandeep Singh in Indian Express, SEBI's press release and circular.

Ajit Dayal pointed out to me that the practical implication of this effort has been greatly undermined by the requirement that the physical PAN card has to be verified before an online transaction takes place. In other words, the canonical online transaction - the ability for a stranger to be able to come up to the website of a financial firm and put in money - is infeasible. SEBI strongly needs to switch the sequencing around: Require the physical verification of the PAN card after the online transaction and not before.

Progress at IRDA

Gautam Bhardwaj of Invest India pointed out to me that as a country, the impact of SEBI's move is limited because it will merely push the distributors away from selling mutual funds to selling insurance products, where the most toxic distribution strategies are to be found. An across-markets perspective is required on the part of policy makers. As long as distributors / advisors are paid for transactions, there will be a bias in favour of churning, a bias in favour of selling products from AMCs that pay the highest fees, etc. As Gautam Chikermane has emphasised, this is a strong argument in favour of unified regulation, atleast for the purpose of all financial products sold to retail customers. While on this subject, see the proposal of a `Financial Product Safety Commission' in the US by Elizabeth Warren of Harvard Law School - op-ed version.

IRDA has also been making progress; it has started asking for more disclosure about how much money is actually invested. There are going to be some red faces when it is revealed that out of Rs.100 paid by a customer, only Rs.40 will get invested in the first year. Monika Halan describes the IRDA initiative as going from 20% transparency to 60% transparency. She emphasises that the burden on customers is the sum of fees and expenses, and when there is transparency on fees, it's easy for financial firms to switch to administrative charges. As many readers will recall, this ease of portraying marketing expenditures as either fees or expenses is the reason why the design work of the New Pension System (NPS) has long emphasised selection of pension fund managers (PFMs) based on an auction focused on one number: the sum-total of fees and expenses.

What is a customer to do?

When I write blog entries like this, I get a fair supply of email asking what should the customer do. Here are my suggestions:

• There is a small group of products that I am comfortable with: there are index funds (both open-ended funds and ETFs) and there is Quantum Mutual Fund. I like the Nifty and Nifty junior ETFs from Benchmark Mutual Fund, which are the lowest-cost index funds around.
• I would encourage customers to avoid the fund management products sold by insurance companies: Buy pure insurance products from insurance companies if you really need insurance, and avoid the bundling of fund management with insurance.
• In all cases, I would encourage the customer to avoid distributors, be very conscious about the grand total fees and expenses being inflicted on you, and pay as little as you possibly can to financial firms. Fund management is a rare field where paying more generally gives you lower quality products.
• Avoid all `New Fund Offerings' (NFOs); do not churn.
• Become a customer of the New Pension System, which is phenomenally low cost, when you get the opportunity. The NPS has no NFOs, no innovative product development, no distributors, just honest down-to-earth low cost fund management.

The agency business of securities firms is fine

While these difficulties afflict the fund management industry, as a rough approximation, I think the securities firms are carrying no fat. Entry barriers are low, competition is brutal, fees and expenses are fully transparent, there is no shades of gray in judging whether the firm performed its job, there is no illusion of performance.

In absolute terms, the charges are high. As an example, see this story. However, as diagnosed in Box 2.8 (page 29) of the MIFC report, the bulk of this story is the array of transaction taxes that have been imposed by MOF and SEBI that are driving up the charges. Once these are stripped out, charges in India are not out of line.

A glance at the brokerage firms in the CMIE database shows some interesting facts. I focus on the performance of the aggregate industry, and juxtapose a bad year (2002-03) against a good one (2005-06):

Parameter	2002-03	2005-06
PAT / Net worth	11.27	23.03
PAT / Total assets	3.93	8.97

These profit numbers are the `normalised' values reported by CMIE, where the bulk of earnings management is stripped out using procedures that are consistently applied across firms and across time. The values reported above are not that different from the evolution seen for the universe of non-financial firms, which I use as a benchmark of performance under fairly competitive conditions.

Fiscal policy to the rescue?

Writing in the Financial Times, Larry Summers says that the odds of a US recession have risen further in the last six weeks, and that there is a strong case for a fiscal stimulus of roughly $50 to $75 billion, delivered to poor people in the US.

What are the coefficients on your Taylor rule?

He says that a sharp easing of monetary policy is a done deal, and that the policy rate will go to roughly 3 percent. I don't see how it's easy for the US Fed to cut rates given how bad things are on inflation in the US. The latest data for TIPS-derived expected inflation in the US are showing values above 2.8%. This is not a pleasant environment in which cutting rates can be envisaged. To the extent that Larry Summers is effectively advocating a high weightage on the unemployment coefficient and a low weight on the inflation coefficient of the Taylor rule, this is a source for concern.

The US lacks a de jure inflation targeting framework for monetary policy. Trusting the Fed on inflation is, then, only a matter of the personalities of the people in charge. The Fed is mistrusted more than (say) the Bank of England where, since inflation targeting is written into the law, there is no question about the credibility with which the BOE will take on innovations in expected inflation. In this paradoxical way, writing down inflation targeting into the law actually gives more space to respond to events. In the US, the law does not tie down Ben Bernanke's monetary policy rule, so he has to worry about how the market sees the coefficients on his Taylor rule, and has to be concerned about the threat to his credibility if he eases rates and ignites inflation.

Can fiscal policy do stabilisation?

A few weeks ago, I wrote a paper titled New issues in Indian macro policy which is forthcoming in a book edited by T. N. Ninan. There, I argue that the right strategy for both monetary policy and fiscal policy in India consists of devoting these tools to the task of stabilising the business cycle. The question arises: Why not lock down fiscal policy into a relatively dumb rule (like the existing FRBM), and leave the entire job of stabilisation to an inflation-targeting monetary policy? I think the answer lies in two parts.

First, a dumb fiscal rule like the existing FRBM is not implementable. If we set out to achieve a 3% central fiscal deficit every year through a dumb fiscal rule, in a bad year, the outcome will be worse. In February 2008, little is known about business cycle conditions that will prevail over 2008-09, so the budgeting process will inevitably go wrong. This will adversely affect the credibility of the fiscal rule, and possibly induce fiscal instability with a non-decreasing debt/GDP ratio.

The second reason is that fiscal policy can, in an ideal world, help do good things for stabilisation. Larry Summers offers four elements of this logic:

The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

He also offers a fifth reason: When there are difficulties in the financial sector, as in the present situation in the US, the effectiveness of monetary policy (as in cutting rates) as a tool for stabilisation is lowered.

These are all good reasons, though some of them are unique to the present situation in the US. I do think there is a case for building business cycle considerations into the fiscal rule. But this is hard; the experience of many decades, all over the world, has shown that fiscal policy is too slow and too politicised. All too often, fiscal policy flirts with the danger of a rising debt/GDP ratio and/or election cycles. The formulation that I offer in the paper mentioned above is one where government always budgets for a fiscal deficit of 1% of GDP, but slippage to 3% is considered acceptable if (and only if) business cycle conditions are adverse.

As Richard Clarida once explained to me, the 9/11 attacks were a singular moment in the history of macroeconomic policy, because on the morning of 12 September 2001, the day he started work at the US Treasury, there was full clarity that a downturn was coming. There was no difficulty of reading the tea leaves with old data; you knew for sure that a counter-cyclical response was needed. US fiscal policy and monetary policy worked very effectively in the aftermath of the attacks. We should treat that episode as being on the frontier of what is possible. Most of the time, what macroeconomic policy can deliver will be worse than that episode.

A part of Indian history that most of us have forgotten

William Dalrymple (of City of Djinns fame) has a book review in The New York Times of a book named The Adventures of Amir Hamza. This book appears to be an epic that was transmitted and embellished in the muslim world, and particularly took root in India. I was surprised and embarassed that I had not heard of The Adventures of Amir Hamza before. Apparently I am not alone, the book seems to have died down in the public consciousness. This new translation as done by the Pakistani-Canadian scholar Musharraf Ali Farooqi, who has worked off Urdu editions from 1855 and 1871, and come up with a 948-page version. As Dalrymple says:

To read The Adventures of Amir Hamza is to come as close as is now possible to the world of the Mughal campfire those night gatherings of soldiers, sufis, musicians and hangers-on that one sees illustrated in Mughal miniatures, a storyteller beginning his tale in a clearing of a forest as the embers of the blaze glow red and the eager faces crowd around.

It sounds fascinating; it reminds me of the oral tradition that led up to the Mahabharata. Ashok Desai once said to me that the reason these epics are so much fun is a process of natural selection where the most quirky stories tend to survive across time. This is the opposite of the modern Internet where every dull paragraph is faithfully archived forever!

Got noticed

In the `BH Economics Blog Awards 2008', Bayesian Heresy thinks this is the best South Asian blog. Even if you have to be a genius to read it.

End of 2007 reading

• Swaminathan S Anklesaria Aiyar on the rupee appreciation.
• I completely agree with his focus on creative destruction. While on that subject, look at this piece on letter writers by Anand Giridharadas and this older piece by Ila Patnaik on the STD PCO.
• I'm not too sympathetic on the difficulties of economic reforms. Leadership is all about pulling off fundamental reforms even when holding a weak hand of cards. Arvind Panagariya's article on the telecom reforms that have made all the difference is a reminder of how far-reaching transformative change - the "first-best reforms" that are generally dismissed by the wise and cynical - gets done by a good leadership even when the odds are against it.
• In 1998, I had written an article about two great investment strategies. Here's another great investment strategy (irony alert) - an article by Dean P. Foster and H. Peyton Young. While on this subject, you might like to read this old speech by Raghuram Rajan.
• Ila Patnaik reminds us that if you insist on pegging the exchange rate, the best strategy is to give up monetary policy autonomy.
• The operating system that stole Christmas by Aaron Edlin of U C Berkeley.
• Ashok Desai tries to understand Narendra Modi.
• Ruchir Joshi's Manifesto of Freedom.
• The Washington Post has a story by Glenn Kessler saying that India has stopped selling arms to Burma. The difficulty lies in the extent to which the Burmese army would then deepen their embrace of China.
• Joschka Fischer has an article saying that NATO should take the Afghanistan problem head-on. Fischer was foreign minister and vice chancellor of Germany 1998-2005, and led the Green Party for 20 years.
• Imagine no boundaries. In these gloomy days, let us all dream that South Asia can become like Europe in the withering away of boundaries.

Critical appointments watch

Position	Date	Outcome
Comptroller and Auditor-General	January 2008	Vinod Rai, 17 December 2007
Secretary, Dept. Financial Services, MOF	January 2008
Chairman, SEBI. link	February 2008
Two members of SEBI
Chairman, IRDA	May 2008
Governor, RBI. link	September 2008
Chairman and members of Competition Commission

Also see:

• Who will fill the hot seats by Tamal Bandyopadhyay in Mint. 4 January, and the associated Experts speak on regulators.

Understanding the foreign institutional investor

For a country that was used to decades of autarky, where most people spent their formative years in a FERA mindset, a key hurdle in re-integrating with the world economy is the incomprehensibility of capital flows. Many people are hostile to capital flows on the grounds that foreign capital is capricious and ignorant. If you can't understand it, it must be a fad :-)

One of the nice things that has been happening in India's deepening engagement with the world is a buildup of data about the international finance aspects of the economy. It is now possible to look at a good monthly time-series with 140 observations with data for net FII inflows. And, it's now possible to look at data for the thousands of firms in the CMIE database and ponder which of them have foreign shareholding and why.

I wrote an article Understanding the FII in Business Standard today which conveys an executive summary of what one finds from these two lines of thought.

The first few paragraphs (looking at the time-series characteristics of net FII inflows) is unpublished work. The results using firm-level data are on the website of the NIPFP-DEA Research Program on Capital Flows and their Consequences (slideshow, paper).