Whose side is SEBI on ?

My latest blog on SEBI's recent directives on Mutual Funds is here.  The post follows:

Assume we are living at a time when we still used boats to travel long distances. Imagine a large, leaky boat about to set out on a stormy sea. Imagine that this boat is about to make a journey that in the normal course will last over a year. Additionally, the boat has had a history of capsizing a few times in the past, often taking with it the passengers. However, each time, the owners are able to pull the boat out from the sea put up a few patches and declare it seaworthy. It would seem obvious that tickets for the trip would be hard to sell especially to people staying in the vicinity of the port of launch.

Now imagine that there is a regulator whose job is to protect the passengers. The regulator is charged with certifying the sea-worthiness of the boat so that the passengers have a safe journey. Over the years, seeing that the boat has not proven to be particularly safe, the regulator declares that all passengers have to decide for themselves what the journey is worth to them. Sellers of tickets are to be paid for their services directly by the passengers not by the boat owners. Meanwhile, the seas become stormier, and ticket sales fall.

The boat owners now demand that the ticket prices should be raised (They obviously form a cartel if you want to use the boats, you have to deal with them). This extra money is to be used partially for rewarding those who sell tickets to passengers. Importantly, more money is to be paid to those sellers who sell tickets to unsuspecting passengers, who live far away, and are therefore less likely to have heard of the experience of earlier passengers. Even more intriguingly, passengers who have already bought the tickets should be charged extra every time a "new" passenger from afar agrees to board the leaky boat. What should the regulator do?

It could of course ignore the lobbying of the boat owners, and insist that they spend money building a more robust boat. It could insist that boat owners pay more to cartographers who can help determine a less risky path to the destination. It could insist that buyers have a right to know that that besides the boat, there were other less dangerous paths to the destination as well. It could mandate the creation of boats that are safer. It could insist in fact, that their primary mandate was to protect the passenger, and not the well being of the boat owners.

What would you say of a regulator that instead, agrees whole heartedly with the boat owners, caps the payment to the cartographers, increases the price of the tickets and increases incentives for those getting unsuspecting passengers to the boat even forcing existing passengers to pay more. Who am I talking about replace "boat owners" with "Mutual Funds" and you have your answer.

Undoing its own logic

In 2009, SEBI decided to ban entry loads for mutual funds the argument then was that investors should determine for themselves what services of "fund advisors" people who sold them funds was worth to them. Investors could decide how much they would pay. A laudable objective.

This change effectively killed a whole range of distributors where clearly, the investor did not feel that enough value was being added to be worth paying. Inflows into equity mutual funds fell as well.

The moot point is whether the inflows fell as a result of poor market and fund performance or because of a lower distributor base.

A look at the graph above shows that the problem is not that the assets did not increase. Just that equity fund assets did not grow. Most equity funds in the period post the ban of entry load (August 2009) have delivered poor returns to investors (category average for 3 years for equity large cap has been 4.5% per annum while even liquid debt funds have delivered 7% per annum). Since the equity markets have performed poorly, long-only funds too have performed poorly some more so than others. Long-only refers to a situation where fund managers are only allowed to buy before they can sell. An alternative would be to sell first and then buy back at a lower price if the market were falling. Almost all mutual funds are "long-only". In such an environment, would it be expected that there would be a rush of investors into equity funds? Not in the view of this writer.

What therefore was the rationale to re-impose the entry load which is what SEBI has mandated as per its latest guidelines? Under the guise of increasing investor participation, SEBI has made the following changes (a) entry load has been increased if mutual funds were to raise money from centres other than the top 15. 

Astonishingly, it has allowed mutual funds to charge the extra load to other investors of the fund as well not only the far-away ones (b) it has passed on the service tax that was earlier paid by the asset management company to the investor (c) it has capped the brokerage that can be paid to the broker who provides research and trade execution to the fund house and incidentally provides the fund manager the inputs to enable him or her to make investment decisions after considering multiple view points.

The product is faulty, not the sales effort

First and foremost, SEBI could have allowed mutual funds to have investment styles which are not only "long-only". The market offers enough instruments today to allow a skilful fund manager to trade both ways and generate "alpha". By allowing manager to only buy, the ability to sensibly exploit shorting opportunities is unavailable to managers. The recent Alternative investment fund guideline is a step in direction of allowing shorting as well, but the large ticket size per investor (currently Rs 1 crore is the minimum per investor) is a big entry barrier.

Another could have been the ability to manage a multi-asset fund. Here of course the plethora of regulators offers an impediment. So we have the strange conundrum that each individual can be a "multi asset class hedge fund" by himself there is no bar for an individual to trade in equity, commodity, currency, gold or real-estate, but no investment professional or fund house can offer such an investment vehicle to investors. A mutual fund cannot invest in commodities for example an asset class that has done well in the same years that equity has performed poorly. But if this is the problem, should it not have been addressed?

Clearly this is a case where the wrong question has been posed and answered. Many representatives of mutual funds and distributors would have presented their view points to SEBI. I wonder how many investor associations did. 

The views expressed are the personal views of the author.

What to expect from the new CEA

I have a new blogpost on CNN-IBN's India Blog site. The link is here. I am also copying the blogpost below:

Last week, the Indian government appointed Dr Raghuram Rajan, a distinguished economist, as its chief economic adviser (CEA). The CEA advises the government on possible policy options and priorities. There are no executive responsibilities other than to prepare the various economic reports that are presented to Parliament - including the Economic Survey. In this context, it may be useful to look at the policy preferences of the new CEA.

In April, Rajan made a speech in New Delhi in the presence of the PM where he signed off with "I have been frank as an academic, that is the only value I bring". This suggests that perhaps he thought that his speech would not be to the liking of his listeners. But was it really that radical?

The speech (along with my somewhat liberal translation for the non-economists) identifies some issues with recent economic policy:

"Rent, patronage, or entitlement enhancing measures have sailed through."

"Private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth and continuing government transfers and subsidies. The result: The gap between our spending and our saving is making us dependent on short term foreign inflows to a dangerously high extent."

My translation:

Policy paralysis led to bureaucratic/political adhocism, encouraging corruption. India's unwashed masses have been satisfied through hand-outs in the form of subsidies for which there is no apparent way to fund.

The Government has raised minimum support prices for agri commodities at much higher rates than the rate of inflation. Along with free hand-outs (referred above), and forced lending to rural sector through compulsory priority sector lending, we are consuming well over what we save. Soon we will need China to fund us!

So far, I see no problems with the diagnosis. The problem starts now!

Rajan says: "We need a common minimum programme across all sensible political parties to ensure that we stabilise the economy and foreign investor perceptions quickly."

Here we have it. By implication, democracy in India is a problem. If you don't agree with policy wonks of the government, you are not "sensible", and foreign investors are more important than local.

In reality, democracy is good for the economy as are policy disagreements. Enough data exists to prove it. One example is that India's growth rate has gone UP significantly in the period since we have had coalitions ruling the country.

Additionally, most large Indian houses have been investing overseas (perhaps in quanta at least as large as inflows) over the past few years. That should cause policy makers to pause and see why domestic industry does not see the potential in India while we are supposed to invite foreigners.

Rajan goes on to suggest that by 2000's, "powerful elements of the political class which had never been fully convinced about giving up rents from the License Raj ..., had by then formed an unholy coalition with aggressive business people ..... The new post-License Raj equilibrium became the Resource Raj."

The statement is misleading seeming as it does to suggest that the unholy politician/industry alliance is new. When did India ever have a strategy to offer national resources in a transparent manner? It was always through licensing which is by its nature open to corruption. Only difference this time the scale of corruption is unprecedented under the current dispensation.

So what is the solution that Rajan prescribes? He says, "simply moving our millions from low productivity agriculture to rural industry or services will give us growth for years to come, provided we are willing to do the minimum necessary to collect the low hanging fruit."

How do we do this? "We need to liberalise sectors like education, retail and the press, freeing entry and improving customer choice. We need to transform more government-owned firms into well-managed publicly owned firms which are free from political influence or government support. And we need to evolve transparent means of pricing and allocating the bountiful natural resources in our country."

Get the connection? Huh? Well I don't too. How does letting foreign investment in the press, retail or higher education (he speaks of higher education, not primary, when he speaks of liberalisation somewhere else in the speech) help in increasing rural industry or services? Privatisation of government-owned companies has already been ruled out of the policy tool box of the current government and is unlikely to find its way back.

Unfortunately, the rest of the prescriptions too don't offer anything new: increase fuel prices (instead of curtailing wasteful government expenditure), find a policy for allocation of natural resources (non contestable except that no format has been suggested, so this is a motherhood statement and no more) and look out for foreign investors (I fail to see why it is not necessary to be kind to Indian investors as well).

So far, what one sees of the new CEA seems to be only old wine in new bottle. Worse, it does not seem to be based on fact or cogency of argument. Hopefully the reality will be better for India's economic future.