Last month, I suggested that intrusive regulation was not a solution to incentivize “sensible” retail investor participation in equity and equity derivatives markets. The argument was based on evidence that retail investors learn better investing habits over time. This, combined with evidence on the distorting effects of regulation on a range of financial market outcomes in India (including my work on Indian mortgage risk) suggests that it is more appropriate to “leave the retail investor alone”.
Is there a problem, though? Many persons, including the country’s previous finance minister, routinely expressed concerns about the overall rate of participation by Indian investors in equity and bond markets. There are also related concerns about the propensity of the Indian investor to overinvest in unproductive assets such as gold. Anxiety about the lack of direct retail investor participation in primary markets reached such an extent that the Securities and Exchange Board of India (SEBI) even entertained—to my mind undesirable—proposals forcing firms to offer optional fully convertible debentures, that is, a stock plus a put option, to retail investors in initial public offerings (IPOs).
If there is a problem of low participation in formal markets, how can we solve it? First, we need to stop thinking that direct retail investment (picking stocks) in the equity or bond market is the most desirable option. This means that focusing attention on why retail investors aren’t jumping into IPOs is probably the wrong question for policymakers to focus on.
A sensible investment choice, as most finance professors will agree, is to invest indirectly in a low-cost passive index fund, which tracks the performance of a diversified index such as the Nifty or the Sensex. However, most index funds in India charge relatively high costs (up to 1.5% of the investment amount), compared with the level of index fund costs seen in more mature equity markets around the world (for example, the global index fund provider Vanguard just cut costs to roughly 0.30% for a wide range of its index funds).
Despite these relatively high index fund costs in India, they are still cheaper than active mutual funds, which is the focus of sales efforts by financial services providers in India. Turn on your TV most days, and you can see adverts for high-cost active mutual funds promising the moon in terms of returns to prospective investors.
Mutual fund providers will argue that in India, active mutual funds have outperformed the index. The appropriate response is that indexation hasn’t gone far enough—the creation and distribution of more passive low cost index funds which track sub-indexes such as tech stocks or “value” firms is the solution, not pushing high-fee active mutual funds to consumers.
Second, a major force in “long-term” equity investing in markets around the world is the presence of insurance companies and pension funds.
Retail investors participating in formal pension plans or in insurance markets obtain indirect exposure to equity and bond markets through this channel. However, this channel hasn’t been allowed to flourish in India to the extent that it has in other global equity markets.
Indian pension funds have always suffered from heavy regulation, nipping this source of equity investment in the bud. There have been longstanding (recently resuscitated) proposals to allow the Employees’ Provident Fund Organization (EPFO), India’s largest retirement fund, to invest in equity markets, but for now, public pension fund money does not flow into the Indian capital market.
Even in corporate bonds, investment by EPFO is a tiny fraction of its total investment owing to mandatory restrictions. On the other side, insurance companies have suffered a significant trust deficit as a result of mis-selling scandals—a case of regulation not being enforced appropriately.
This discussion of insurance companies brings up the issue of trust in capital markets. This is a hugely important force. There is much evidence on this link: one well-known study uses data from Italy and the Netherlands to show that people who feel they can trust others are up to 50% more likely to participate in the equity market, and invest larger amounts when they do participate.
Another recent study shows that wrongdoings by companies have a significant effect on retail participation in equity markets. The findings show, as you might expect, that wrongdoings by companies (think Satyam) decrease participation in such stocks. Much more importantly, they appear to decrease participation across the board, that is, they reduce the tendency for retail investors to participate in equity markets more generally.
The bottomline is that we should remove unnecessary regulations and quantitative restrictions on participation, and focus regulation and enforcement on improving retail investors’ trust in financial service providers and firms. If, as the Financial Sector Legislative Reforms Commission suggests, we squarely focus on consumer financial protection, we will make a big step in the right direction. Assuming these changes are implemented effectively, we will certainly see increased participation in formal markets.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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