Do we really need mutual funds anymore?

Sebi, the markets watchdog, has raised an existential issue for the mutual fund industry. The other day, chairman CB Bhave asked the industry to introspect: “You need to question what the rationale for the industry is”. His point: If investors really found value in mutual funds, the latter would not need artificial props to sell its products. “If we have not been able to convince investors even with thousands of schemes, there is some problem with the products.”

He could say that again. Though the Indian mutual fund industry seems large with assets of around Rs 7,50,000 crore under management as at the end of May, that figure hides a larger truth. Three-quarters of the money is in income, liquid or non-equity funds. And the bulk of this is corporate moolah, hot money that flows in and out of the industry’s coffers depending on liquidity conditions. Prima facie, Bhave’s suspicion that the industry is not really delivering real value to retail investors holds good. There is a problem somewhere.

If you were to ask the industry, it will say it is up against two problems: an unsympathetic regulator who banned entry fees and upfront distributor commissions, and unfair competition from unit-linked insurance plans (Ulips), which are actually mutual funds masquerading as insurance schemes. Insurance is apparently easier to sell as an investment rather than as just risk cover.

To be fair, Bhave did try to blast Ulips out of the water, but the finance ministry intervened on behalf of the insurance regulator, Irda, and shooed Sebi away. However, we will come to this point separately. The issue to examine is whether Bhave is right in questioning the industry ability to deliver value to the retail investor.

Let’s start with basics: the main value proposition of the MF industry is that it brings market and stock picking expertise at low cost. But entry loads and high upfront distributor commissions neutralise the second advantage and leave only stock-picking skills as the driver of customer value. But here retail investors have other options.

Stockbrokers offer advice at almost no cost. Moreover, anyone willing to do a bit of research on the net and read the business dailies can get the same info with some effort. Pared down, the real value proposition of the mutual fund industry is thus saving the investor the hassle of doing his own homework.

On the other hand, there is a downside to investing through mutual funds. Investing through a mutual fund has its own risks. As investment aggregators, fund managers need to buy or sell large quantities of stock. This means they have to restrict themselves to large-cap stocks where their actions do not drive the price up or down dramatically. MFs cannot easily enter mid-cap or small-cap stocks — where the biggest gains reside — because large buying or selling dents the net value accruing to the fund.

The upshot: most MFs stick to the big index stocks where their performance is largely comparable to broader index movements. The investor may thus be better off investing in low-cost index funds or exchange-traded funds rather than mainstream, diversified funds. The funds that beat the indices are usually the ones most skilled in timing the markets or those that are just plain lucky. Picking good funds is thus as difficult as picking good stocks.

What emerges is this: if the key (theoretical) value propositions of mutual funds are decent returns, low management costs and safety of capital, many equity funds fail the first two tests and non-equity funds have competition from other avenues with lower risks such as bank fixed deposits, debentures, post office savings schemes, et al. Income and debt funds carry as much risk as equity funds since their net asset values depend on the market prices of their underlying debt investments.

It is in this context that one must see the industry’s cribs. Railing against Sebi’s diktats is fine if you are really serving the customer and Sebi is getting in the way. But what Sebi has really done is knock the industry crutches down and see if it can walk. If it can’t, it should be allowed to ride into the sunset.

The carping against Ulips is also beside the point. Insurance companies are ultimately not going to deliver better investor value by invading the MF turf. If investors are anyway not too happy with MFs, they are unlikely to be any happier with insurance-tinged MFs. This suggests that even the insurance industry may not be delivering value, and may be deliberately misselling Ulips to entice MF investors in the short-term.

Bottomline: Both MFs and insurance companies need to rethink what they are really bringing to the table.