Now, banks blamed for continuous equity mutual fund outflows!   

November 16, 2010

While banks indulge in mis-selling mutual funds, as Moneylife had warned 10 months ago, it is far-fetched to blame them for steady equity mutual funds outflows and not SEBI’s hasty and utopian rules on mutual fund selling

Almost 15 months after the Securities and Exchange Board of India (SEBI) set in motion extensive changes as to how mutual funds are sold, and well after the regulator's hasty changes started affecting both the fund industry and the investors, the media has started to get agitated against just one of the fallouts of the sweeping measures-how the national distributors are leading investors up the garden path. According to two business newspapers, banks are encouraging retail investors to churn their portfolio, which is leading to lower gains for investors.

Banks are motivated to do this because of SEBI's rules for selling funds. According to the rules, fund companies cannot pay upfront commission to distributors at the expense of fund investors. They can get upfront commission from fund companies and trail commission on assets that their customers have kept with the fund. Banks have discovered that they make more money from the asset management companies on fresh investment (upfront commission of around 1%) and make less if it is a continuing investment (around 0.5%). If banks can get customers to buy and sell three times a year (which is churning), they make 3%, whereas if they encourage investors to buy and hold over a year, they would get only 0.5%. This is what they seem to be doing.

Mis-selling by banks as a possible fallout, (one of the many, as a result of SEBI's changed regulations), may be a surprise to both the regulator and the media, but not for Moneylife, which documented this 10 months ago based on feedback from the Independent Financial Advisors (IFAs). But at that time, neither the fund companies nor the regulator (much less the media) seemed concerned. Now, the regulator seems to have woken up to this obvious consequence of its actions and is bleating that the Reserve Bank of India (RBI) should come down on banks to stop them from churning investors' portfolios.

The Mint wrote on Tuesday last week, "Retail investors, advised by large banks and distributors, exited mutual funds (MFs) after entry loads on these were removed and even as the stock markets continued to rise. Meanwhile, high net-worth investors (HNIs-those who invest more than Rs5 lakh per folio) and those who invest directly with fund houses have stayed invested, benefiting from rising equity markets. Bankers and wealth managers attribute this to the end of entry loads (costs charged to investors upfront at the time of investment, that were eventually passed on to agents as commission), which have meant that large sellers of MFs no longer have incentive to push the product." On Monday, The Economic Times reheated the same information and served it up with a comment: "The ingenuity of national-level distributors appears to be neutralising much of market regulator SEBI's efforts to curb mis-selling of mutual funds to investors."

These reports paint a picture of a well-meaning regulator being undermined by nasty and greedy banks. We had mentioned several times, based on the feedback from IFAs, that the series of actions SEBI took would lead to precisely this. In fact, we had pointed out in January how Axis Bank was charging Rs225 to investors without their consent to the New Fund Offer of Axis Mutual Fund, without the customers knowing about it. (Read http://www.moneylife.in/article/8/3717.html) When the Axis Bank practice came to light, Moneylife argued that "this puts a different light on the entire issue on how distributors can charge their customers." SEBI banned entry loads in August 2009, arguing that customers must have the option to negotiate and pay what they can to distributors. But the Axis Bank move underlined the fact that while it is laudable that customers must have the ability to decide for themselves what they are paying for and how, it is a utopian idea in practice. In reality, distributors who have a strong relationship with customers in some manner or the other and an ability to charge them, will get away by doing exactly that. Customers may neither notice nor protest. Since commercial banks enjoy a relationship of trust with their customers, they may misuse it. This is simply because, with long years of experience of watching both regulators and banks, Moneylife editors had pointed out that banks have often abused the trust in the past, when they have debited millions of customers for a service that they have not asked for. The most notable is the example of Citibank which debited some amount from its customers' accounts for an insurance policy, the Suraksha scheme, which they had not explicitly consented to buy.

We had pointed out that this practice would spread into fund selling and SEBI would not be able to regulate banks. Neither does it have a foolproof mechanism to regulate the distributors. SEBI regulates fund companies. However, funds would not exactly be bothered by any abuse of trust by banks; they would be keen to raise as much money as possible-no matter how a distributor sells a scheme, we had pointed out. Also, many mutual funds are sponsored by banks. We asked, way back in February: "Why would a fund complain about any malpractice? The Reserve Bank of India would also not be concerned."
This is exactly how it has played out to the utter surprise of SEBI, which had pushed a utopian regulation down the throat of the fund industry without thinking it through.

After SEBI implemented a series of changes governing the selling of mutual funds, and then tried to implement a patchwork of futile solutions, money continues to flow out of mutual funds. Between August 2009 and October 2010, Rs24,330 crore has gone out of mutual funds. All this, while SEBI and fund companies have argued that this haemorrhage has nothing to do with SEBI regulations, but investors booking profits. While this no longer washes, pro-SEBI commentators have now found another villain: banks encouraging churning. Unfortunately, even this does not explain why churning by banks should lead to large continuous net outflows from funds. Unless SEBI admits that it has forced a set of regulations without thinking through the consequences, healthy growth of the mutual fund industry seems a remote possibility.

Meanwhile, let's hope that a trigger-happy SEBI does not try to cure the disease by attacking the symptom and banning distributors from churning more than once a year, as another of its pro-investor moves! — Moneylife Digital Team