Trust deficit

Front-end loading by mutual funds has come an end. When will front running by brokers?

It is not the best of times for the securities business. On one side is market volatility that is scaring investors and resulting in dwindling volumes. On the other hand is the increasing pressure from regulators for transparency in proprietary trading and thus squeezing margins. Despite evidences of excesses committed by governments, greed, recklessness and questionable operating procedures adopted by those who manage investors’ money are blamed for the current market turmoil. The outburst of Securities and Exchange Board of India chief at a recent conclave of fund managers and the ban on a mid-rung official at HDFC Asset Management Company have brought to the fore the trust deficit between investors and market intermediaries. Dismissing the highly paid fund managers as “aggregators”, C B Bhave, the Sebi boss, bluntly questioned the existence of the highly hyped fund industry. If the ban on front-end loading of expenses has resulted in display of withdrawal symptoms by the mutual fund industry, front running is the recurring theme at brokerages. Efforts to separate and discourage proprietary trading face an uphill task and so also the practice of incorporating various loads by mutual funds. Online trading may have eliminated the price variation between placement and execution of order but not completely neutralized brokers or their employees from taking positions ahead of their clients. Entry loads may have disappeared but not exit loads. Indeed, Sebi seems to have completed a full circle from blaming brokers for most market ills and encouraging investors towards mutual funds in the 1990s to embarking on a do-or-die mission to cleanse the money management industry over the past year. It does imply that the regulator would either prefer investors to undertake direct exposure to the cleaned up secondary market to handing over funds to others or that the practices at asset management companies are no better or worse than those at brokers.

Are the mutual fund industry and the brokers facing flak for systemic flaws? The mutual fund industry was supposed to be a via media for the retail investors to take exposure to the equity and debt markets. Instead, the primary reason for its existence seems to be for the bulk investors, that is companies. This is in spite of capping quid-pro-quo transactions of companies diverting cash to the fund for use to boost their stock prices. There are many reasons for this state of affairs: First is of course the volume game, which fattens fees. Once a fund builds a comfort level with the company, both save on distribution charges. This makes selling to retail investors an expensive proposition. Hence, there is tendency of AMCs to lock in their fees through loads, especially for smaller amounts, rather than fees based on performance Second is the high capital requirement to float an asset management company, which increases reliance on corporate clients and permits entry to companies, banks and financial institutions. It also leads to fluctuation in corpus on large withdrawals. The third is the taxation angle. Dividend from equity mutual funds is tax free, while interest on fixed deposits is not, attracting corporate subscribers. The fourth is the illusion of security-of-a-fixed-deposit-cum-returns-of-the-stock-market combo created by the mutual fund industry by using the personal finance media. Ranking of schemes only reinforces the mirage. Unlike stocks, which discount forward earning, mutual fund investors are lulled into opting for schemes based on track record in spite of the Sebi-inspired disclaimer of past returns being no guide to future performance.

Decimating mutual fund is as impractical and counterproductive as trying to do away with brokers. There is a symbiotic relationship between the two. Brokers need institutional investors to boost volumes. Fund managers rely on brokers to offload or mop up shares in bulk without causing price tremors. At the same time, there is a need for serious introspection by these market intermediaries to find out how they could go about their business without frustrating their clients and the regulator. The mutual fund industry has been a proponent of self-regulation. To aspire for this status, mutual funds must put a cap on large subscriptions, bring down asset management and expense charges, and base fees on returns generated or performance in comparison with benchmarks.. A certain portion of this fee can be shared with distributors. This will ensure there is no mis-selling of schemes based on commission as well as survival of the efficient. Sebi should ease capital requirement norms to reduce AMCs’ dependence on corporate subscriptions. This has facilitated companies and financial institutions rather than experienced money managers to float mutual funds. It is now accepted that smaller corpuses are easy to manage and give better returns. The ceiling on each mutual fund’s holding in the equity capital of a company undermines the necessity of large asset base. Moreover, funds with modest corpuses can focus on mid-caps and bring about welcome changes in their corporate governance, thus increasing market depth. More funds with personalized service would widen the basket for high net-worth investors looking at PMS to cater to their needs. Brokers, too, would be able to spread their risks instead of depending on handful of funds for volume business and to resist the temptation of running ahead of their clients as the mass of orders of a small sized mutual fund may not be adequate to influence the course of the market. Swift punishment such as suspension of registration, which will hurt the broker for lax internal compliance, can do what well intention regulations on inducing transparency in proprietary trading cannot.