Sebi vs economics, who will win?

Posted on September 9, 2010 | Author: Sandeep Parekh | View 1114 | Comment : 15

Sebi's recent regulation deprives the mutual fund distributor of any incentive to sell the product, and this is killing the industry. The mistake can and should be rectified.

artical Picture Sebi has faced strong currents of vitriolic anger from mutual fund distributors and the mutual fund industry. This venom is rarely displayed in the mainstream media, but a look at comments on websites discussing the issue bares the raw fury of the industry as a whole and the distributors in specific.

While the anger may be seen as a sign of self-preservation by a profession, there is a fundamental problem with Sebi’s regulations. The problem is that Sebi is trying to fight economics.
The issue in brief is as follows. The mutual fund industry has three cogs to its wheel, the asset management company (AMC), the distributor and the investor. Over 80% of all funds are sold by distributors to investors, the balance being sold directly by the AMC.

The distributors provide many valuable services and provide advice to investors and were compensated by the AMCs, who shared expenses/commissions/loads charged to investors with such distributors.

Clearly, like any other financial product, there is mis-selling by several distributors to favour the products which generate the best commissions rather than those which were most suitable to the client.
From June to August 2009, Sebi changed the rules of the game to curb mis-selling and conflict of interest which arises out of a distributor selling the most lucrative product. The regulator outlawed entry loads (a charge on purchase), capped exit load at 1% of redemptions (a charge on sale) which could previously have gone up to 7% and barred AMCs from paying distributors a commission out of the initial kitty.

Distributors now need to negotiate with investors the initial commission and the amount must be paid by separate cheque to the distributor. This is of course great for investors who don’t need to shell out an inbuilt fee with their purchase and also the rule change reduces the conflict of interest of selling with the motivation of earning commissions.

Unfortunately, the law of unintended consequences results in the product not being sold at all and the industry has shrunk dramatically since the rule change was introduced.
So where did Sebi go wrong with this seemingly benevolent action? The answer is economics 101. Imagine going to the market to buy a packet of biscuits, and imagine a law which says the packet must be sold at cost, and that must be the cost to the retailer with a virtual ban on the manufacturer to pay the retailer any mark up.

Now imagine that the same law says that the profit must be negotiated between the consumer and the retailer. The system is unlikely to work which is why such laws don’t exist for ordinary products. A version of this economics resulted in the fall of communism.

The theory of getting products at cost to the consumer would result in the product not being sold, and in further consequence, the product will not be manufactured leading in turn to demand remaining unsatisfied.

The conflict of interest exists in the market for biscuits as well, how often will a retailer sell you the product with the lowest margins? That is hardly an argument for selling at cost with negotiable profits.
The Sebi board agenda note, which discusses the issue seems to solve the issue at hand inappropriately and uses partial material from the equivalent US law. First, the note goes into issues of transparency of commission structure, but ends up outlawing commissions instead.

Clearly, few would quarrel with the right of a regulator to mandate higher disclosure norms i.e., mandate that the product bought be marked separately from the commission the distributor makes on the product. Investment products are indeed different from the market for ordinary goods and thus do require higher regulatory protection.

The disclosure of such commission and also of trail commissions (paid on a continuing basis) would have dramatically reduced the problem of conflict, of misselling and of churning.
Instead, the action of Sebi has the consequence of eliminating the returns of the intermediary in fact (though in theory a fee could be negotiated). Second, distributors have abandoned the low cost mutual fund structure to sell the even more load bearing insurance product — Ulips which gives them juicy returns.

This move was the genesis of the very public and unnecessary spat between the securities and insurance regulators to regulate Ulips. Third, with ever lower expenses and loads mandated by the regulator (not all countries mandate a cap on expenses and loads), the extent of mis-selling and conflict is more on the fringe rather than an urgent issue to be resolved.
Fourth, the note ignores public comments of which less than 1% support the move, on the grounds that the comments seem to be rigged.

Fifth, it relies only on one regulation from the US regulations of mutual funds ignoring that the US system allows not only what is known as 12b-1 distribution fees (which is capped at 1%), but a whole host of other fees like purchase fees, redemption fees, exchange fees, account fees and operating fees many of which are shared with distributors.

An entry load, which can go up to 8.5%, is given by the AMC to the distributor, an exit load which also goes to the distributor has no cap. Thus to rely on the cap on one out of a dozen fees from the US context is inappropriate and to outlaw distributor commissions after talking of transparency is not even solving the issue at hand.
Clearly, Sebi is not all knowing and is allowed to make mistakes, specially if they are made with good intentions. But the writing on the wall is quite clear after months of shrinking of a well regulated industry. There is no shame in rectifying the error even at this stage.

Instead of going back to business as usual, a good middle ground could be to mandate clear disclosures in simple language in the offer documents and maintain the overall caps on expenses, while remaining agnostic as to how much of the expenses and commissions are shared with the distributor. We don’t need a wonderful operation with the patient dead.

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Comments (15)

  • It is somewhat laughable.It was done by SEBI to curb Misselling but the fact of the matter is No distributor is interested in Selling the Product itself now!!! Banks who were being blamed by SEBI for Churning and who used to dominate major sales of the industry are busy selling only PMS and Structured Products!!!

    Posted by Vishal Mehta,Head Wealth Managment at SUBRAS INVESTMENTS|24 Sep, 2010

  • Who is getting more commission - The MF Agent or the Insurance Agent? See the facts on

    Posted by Anand Agarwal,CEO at Samvardhan|20 Sep, 2010

  • yes, misselling should be stopped ...otherwise thr will be no investors investing in t future...!

    Posted by jaydeep nayak | 20 Sep, 2010

  • SEBI Vs IRDA war over ULIPs. I have prepared a small note and put it up on

    Posted by Anand Agarwal,CEO at Samvardhan|12 Sep, 2010

  • SEBI has done well in regulating the Mutual Fund industry in the best interest of the retail investor. The doing away with the entry load and the capping of the exit load has been well taken by the investors who invest their hard earned money in these funds and the investors are happy with SEBI's reforms. SEBI being the capital market regulator has the sacred-most duty of investor protection, which it has done in an exemplary manner. This article itself is an attempt at misleading the public against a well meaning regulator. What the SEBI has done is down to earth practical and pragmatic. There is nothing like fighting economics in what SEBI has done. Why should at all the investor pay something like the entry load for subscribing to units of Mutual funds and why should he care about ...See More

    Posted by SOORAJ KUMAR P M | 10 Sep, 2010

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    Posted by Pradip Kumar Daftari | 10 Sep, 2010

  • SEBI is bent upon killing the Mutual Fund Industry and the sharemarket. The so called policymakers of SEBI feel they are the only honest and everyone working in this industry are dishonest. The service contributed by SEBI as on date to the Mutual Fund insutry is very valuable(de- evaluating??) It is the basic fundamental / common sense rule that any person who renders any service is bound to charge for that. What does Govt do? Without contributing anything, they charge service tax and waste that money on corrupt politicians. SEBI is puppet in the hand of politicians. Let SEBI do anything, smart investor will definitely seek expert advise and then only invest their hard earned money. In fact private mutual fund advisor should take this as opportunity and start advising only on payment ...See More

    Posted by girishmarathe | 10 Sep, 2010

  • My view is that the SEBI's regulation is untimely and unfair for the mutual fund industry. ULIPs (high incentivizing products) are being sold in the name of Mutual Fund products. When the investor finds that there is a huge dent in his investments (in ULIP), he feels cheated by Mutual Fund. The fact remains that most of India's population cannot differentiate between ULIPs and Mutual Fund Schemes.

    Mutual Fund Industry is still in nascent stage. The policy makers would know that it is important for people to invest in Market Related products and not into products with assured returns. Even for selling Fixed Return products of Post-offices, the Agent is paid upto 1%. Why to deprive the Advisors who are the ambassadors and have contributed so much in the development of this ...See More

    Posted by PANKAJ | 09 Sep, 2010

  • Can Mr. Bhave , Sebi and all politician works for the nation without taking a single rupee,incentive or salary
    ask him is it possible for Mr. Bhave and SEBI ? If he wants to become a real hero.
    The answer all the people knows very well. If the distributor didnt earn a single rupee then why he gives a honest door to door service.Problem is arrises very much in coming future when no body sell the mutual fund. And misselling of various component are increasing and real product makes aside.

    Well Done Mr. Bhave

    Posted by kirang | 09 Sep, 2010

  • The problem is in India we dont want to appreciate the people who earn money with hard work and marketing skills. All these law makers sitting on the top position only talk of the common people but they are not commited to it. To provide better returen to the investers there other loose ends which needs to be plugged at the AUM level. The exorbitent salary to the fund managers and other cost which reduces the return to the investors can be made more transparent. We always hammer the soft target and they are poor advisor. Ok now we have stopped canvassing and selling the Mutual fund let the SEBI bring the business for Mutual fund houses.

    Posted by RAMAKRISHNAN N IYER , sub-broker at kotak securities ltd. | 09 Sep, 2010

  • I feel that two most debated aspects are mis-selling and commission to the distributor.
    In India or the world no business can survive without fore end distribution incentive. A large success of capital building was possible from masses in professionally manged equity funds because of huge distributors network, they spoke in the market what asset management companies have told them after they are all certified by AMFI.
    ...See More

    Posted by Vinay Kumar S M | 09 Sep, 2010

  • No doubt the intentions of Mr. Bhave are noble but they turned out to be unpractical.

    Mr. Bhave should be promoted to regulate the Real Estate Industry/CIDCO. With shameless nexus between the builders and politician, he is best suited to clean this mess.

    Posted by guru | 09 Sep, 2010

  • The SEBI's new regulation does not go well with the principles of economics. I apprehend it would invite more issues than it seeks to resolve. In fact, a more rational incentivisation pattern is what is required to infuse vibrancy in mutual fund sector.

    Posted by N.Vijaygopalan , Dy.General Manager at Manappuram Finance | 09 Sep, 2010

  • The article puts it rightly that there needs to be a better disclosure system for commissions, in offer documents to reduce mis-selling to some extent and lessen the conflict of interest. The regulation though with good intentions is not benefiting the industry and definitely not helping the cause.

    Posted by Karuna Krishna Murthy Iyer,Area Manager at Sundaram Finance Ltd|09 Sep, 2010

  • The article has very well put forth the issues plaguing the new regulation by Sebi. It is indeed a regressive step for the mutual fund industry. In fact the ruling seem to further the same issues that it looks to curb. The mis-selling still exists with the distirbutors slowly deserting the low-cost mutual fund structure. Sebi needs to wake up and set right the wrong done.

    Posted by Sri Lakshmi,Asst Fund Manager at ICICI Bank Limited|09 Sep, 2010

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