India’s Sebi responds to fund manager frustrations

Armed with a box file of fund manager gripes, AsianInvestor travelled to Mumbai to meet Sebi’s executive director Kavasseri Narayanan Vaidyanathan, who ran a mutual fund for seven years at Morgan Stanley prior to taking up his role in June 2009.

There is concern that some of Sebi’s regulatory efforts have been to the detriment of industry growth. How do you feel about that?
K.N. Vaidyanathan: I understand if someone says control and growth have to be traded off. Regulations are checkpoints, they are filters, they are not here to stall growth. The problem is, growing muscle is growth, growing fat is not growth. I believe the industry is now better positioned to grow muscle. I believe it is shedding fat. Obviously in the transition phase it will look smaller.

When you say losing fat, would you welcome more consolidation in the industry? [There are 44 AMCs registered with Sebi, of which 41 have launched mutual funds]
If I look at 41 players in a game of musical chairs, that looks too many. There have been a finite number of investors whom distributors have played musical chairs with, less than 1% of the population. But if I look at the headroom and the opportunity to grow, then 41 may be too few. The problem is not about the number of players, the problem is about the size of the target market.

When you say musical chairs, you’re referring to distributors? I think people see the benefits of Sebi’s ban on upfront loads in 2009, but they argue it could have been phased in, as it was in the UK with the regulator’s Retail Distribution Review.
Two things. One, if you want to make an omelette you have got to break an egg. You can’t just sit and admire it. Two, this is a $1,000 per capita income country. If something good has to be done for society, then do it today. It is not a $40,000 to $50,000 per capita income society where I can afford to say, ‘let’s take a longer-term view’.

That’s the philosophical view, now the numbers. The cost of raising net 1 rupee in the mutual fund industry for calendar year 2003 was 10.5%, in 2004 it was 15%, in 2005 it was 9%, in 2006 it was 8%, in 2007 it was 11.5%. If the upfront load was 2% and NFOs [new fund offers] earn 5%, this gives you a sense of the level of churn in the industry. The entry load was a vicious circle. Asset managers were paying to support a game of musical chairs where distributors shifted investors from fund to fund, and this entire game served the economic interests of only one species, the distributors. I cannot see what economic purpose it served asset management companies.

The total net inflows into the mutual fund industry over 10 years is one third of what the banking industry gets every year, and the banking industry pays no loads.

But everyone needs a bank, while not everyone needs mutual fund.
Fair enough. You have to serve an economic purpose. So what did this [churning] do? It only made the fat man in the middle even fatter. It went against the interests of investors. The collateral damage it did to the industry is it forced asset manager to launch newer and newer products. Churning goes against the grain of the asset management business, which is about scale. That is why it has sexy valuation, because it is an annuity business with a stable asset base.

So what we have done is steered the ship called Mutual Funds, which was running towards distributors, and turned it towards investors. Obviously if you are taking a ship and turning it around, what was a $200 billion industry, it will have an effect. There is a minority community which has lost out, we know that. But there is a majority community which has benefited. As a conscious effort Sebi discouraged new products, because we realised this was the cause of all this.

But what it did was turn distributors to other ways of making money, notably via insurance-linked products?
But it’s changing.

Yes, Sebi moved to tackle the insurance industry head on last year.
We interpreted the law one way, and felt they [insurers] were running surrogate mutual funds. We therefore took steps, the law was changed and we respect the new law. But insofar as what it did, it did a world of good for investors. We have sought to bring down costs, increase transparency and make asset management companies more accountable. The insurance regulator is doing exactly the same.

Everybody entered this business knowing full well that several components of it were unregulated. Any smart businessman know it is a matter of when, not if, the unregulated becomes regulated. When unregulated becomes regulated, excess profits disappear.

Does the distribution industry need to be regulated?
Absolutely, it needs to be. But for asset managers, it is important to remember that you impanel the distributor, not the other way round. You pay the distributor commissions, so you have a right to tell him to adhere to certain practices. We have written to asset management companies and said ‘please adhere to these kinds of additional checks when you appoint distributors’.

How long will it be before there is full regulation of the distribution industry?
It is difficult to say it will happen in ‘x’ number of months. I should think all this will get done in a reasonable time. What is important is that there is widespread acknowledgment in the country that something needs to get done. Now it is about translating that into a set of rules.

Do you see industry growth as fundamentally in the interests of retail investors?
I genuinely and passionately believe in mutual funds, but the growth of the industry is different from ‘development’ as the regulator sees it. The regulators job is not about growth in the AUM of mutual funds. It is to make sure that anything that can get in the way of spreading the concept of mutual funds, of distributing and enabling people to subscribe to mutual funds, is removed. I can’t force somebody to buy a mutual fund, but I can remove the barriers to entry.

So for example we have embarked on an investor awareness campaign to tell people about the benefits of investing in mutual funds. We are pushing the industry to do something like that.

There are only two issues in life – mis-selling and mis-buying. Mis-selling will be addressed in stages as we tighten the regulatory framework on distributors. Mis-buying will be addressed by investor education and awareness. In both I think the regulator has a big role to play. We are now looking at what is the simplest way to buy units over the internet. This country is also embarking on a big project called UID, so every citizen has a unique identification. If every citizen has been uniquely identified, why can’t we simply piggyback on that for a KYC [know your customer] process?

What about educating distributors or even state banks, which have this vast reach across the country?
I think we need to be careful here. When we talk about education and awareness as a neo-government agency, that will be targeted at investors. The others are in a commercial business. It is not my job to train them.

What needs to happen to increase the low penetration rate for mutual funds?
The challenge for the economy is that if we can step up the return on our savings, this country will go from 8% to 10% GDP growth. What we need to understand is that this is a huge market and the first principles of marketing tell you that within a market there are segments.

There is a stereotype in this country among mutual funds: equity means retail, debt means wholesale. Now that to me is the first myth that needs to be shattered. The mutual funds have done an outstanding job in debt management, but they do not go and talk enough about that to the retail investors. I believe you need to bring people up the food chain on risk appetite. They are not aware of the benefits of mutual funds, so the first product you don’t go and flog is some 20-stock equity portfolio. You need to get him comfortable with the concept. The currency in this business is trust. You need to offer low-risk products first in which you have a terrific track record, fixed income products. What we have done on the debt side, we have rewritten the rules to de-risk the business, to make it transparent to the investor, and reinstate mutual funds as a pass-through.

Would it help also if fund manager were able to get better access to manage pension fund and insurance money?
In India, the regulatory structure is around products, with each product – banking, insurance, capital markets and pension funds – having an independent regulator. Products that straddle multiple regulators can be launched through the joint sign-off of the respective regulators. For example, currency and interest rate futures were launched by stock exchanges through a joint process of RBI and SEBI. These are evolving and there could be more such joint initiatives in the future.

What does the scheme to allow retail foreign investment directly into Indian mutual funds mean when it comes to issues like know your customer?
As a country we do not want any compromise on KYC, FATF, PMLA guidelines. We believe we should attract money from jurisdictions we are comfortable with. The best track record of performance is domestic, so foreign investors should get access to that. And Indian managers should get a shot at managing that money. Indian mutual funds are among the better regulated, cheapest investment products. They should be able to stand scrutiny in every jurisdiction.

There has been some media speculation that your contract at Sebi is coming up for renewal. Do you plan to continue in your role?
It is an institution called Sebi making the changes, these changes are driven by the institution.

What do you regard as your greatest achievement and greatest challenge?
I think we have significantly de-risked the business, which suits the investor and the asset management company. I think we have stepped up on investor-centricity of the mutual fund industry, the benefits of which will be felt over time. And I think there is a lot of work to do in investor awareness and education. There is no such thing as overdoing it there.

(See AsianInvestor's May issue for a feature on mutual fund management in India featuring comments from Sebi's KN Vaidyanathan).