Effective competition is supposed to act in the best interest of the consumers. "We like to think that free market functions in a way that protects us from inferior or unnecessary products," writes Columbia Business School faculty Sheena Iyengar in her new book The Art of Choosing.

But that does not seem to be happening in the context of the retail investor in India who can choose between the high commission paying unit linked insurance plans(Ulips) and very low commission paying mutual funds.

Unit linked insurance plans are essentially investment plans which come with a dash of insurance, but are allowed to pay a commission of as high as 40% of the premium paid during the first year of the policy. In case of mutual funds 100% of the investor money collected gets invested.

Over and above this over the last five years, the average return of an equity mutual fund has beaten the average return of equity oriented Ulips by more than 20%. The 25 best mutual funds on the other hand have given an absolute return of more than 80% in comparison to equity oriented Ulips.

So if performance was the criteria and the free market was functioning, money would be going into equity mutual funds. But it is not. Equity mutual funds in the last financial year (April1, 2009 to March 31, 2010) saw a net inflow of Rs 595 crore. Ulips on the other hand collected 194 times more money and raised Rs 1,15,314 crore.

The obvious reason is there are perverse incentives at work. Ulips can pay high commissions to agents using the customer's money whereas mutual funds have to largely pay from their own pockets. Insurance companies can use celebrities to advertise their products. Mutual funds cannot. But these are the obvious reasons.

But the truth is a little more complicated than that.

Let's deviate a little into an interesting example that Iyengar gives in her book The Art of Choosing about bottled water brands.

"The two best-selling brands of bottled water in the U.S. are owned by Pepsi (Aquafina) and Coke (Dasani), you'd be... unlikely to see them aggressively advertising their health benefits relative to soft drinks, one of the few they could legitimately make."
The moral of the story: A bottled water brand cannot say it is healthy to drink water if it happens to be owned by a company which also sells soft drinks.

Similar is the case with the Indian mutual fund industry. Not one mutual fund till date has made an effort to communicate its better performance over Ulips in the last five years. Not one mutual fund has made an effort to communicate its low commissions vis a vis Ulips.

If one side of the market cannot communicate what its strengths are then there is no way a market can function efficiently and people of course will continue to buy high commission paying Ulips.

And why is that? The biggest Indian mutual funds are all promoted by companies which have insurance subsidiaries. Be it Reliance, Birla, SBI, ICICI, HDFC, Kotak, Religaire Bharti Axa, ING, Tata, HSBC, Canara or LIC. All these promoters run both insurance companies as well mutual funds. So there is no way any of the mutual funds can come out and compare their performance with Ulips and say their performance is better. It is not in the interest of their promoters.

Over and above that some of these promoters also run banks. And for banks, insurance commissions are lucrative and an easy way of boosting their other income.

In fact a recent survey titled the "India Bancassurance Benchmarking Survey 2010", carried out by Rajagopalan Krishnamurthy of Towers Watson points out " The responses to the survey confirm the assessment that bank distribution in the case of life insurance is currently highly skewed in favour of unit-linked products (Ulip). Ulip sales account for more than 85% of premiums generated by banks."And since collecting these premiums pays high commissions, banks like to sell only Ulips.

So basically it's not in the interest of any of the players in the market to disturb the current high commission paying set up. And you my dear investor are the least of their considerations.

As Iyengar writes "megacorporations exactly decide how much variety their brands will offer...and it's not in their interest to create true variety. Rather, they aim to maximize differences in image, thereby generating the illusion of variety and attracting the greatest diversity of consumers at the least cost to themselves."
Need we say more?