Home / Opinion / Mutual funds 2.0: Should Sebi do an RBI?

India’s prosperity will depend on how the country invests its financial savings. This task falls squarely on the financial services industry and its regulators. The Reserve Bank of India (RBI), in its wisdom, has felt the need to license banks with varied business models to aid financial inclusion and innovation. Similarly, as capital markets grow in importance in the allocation of financial savings, the Securities and Exchange Board of India (Sebi), too, may need to evaluate the need for innovative licences for the mutual fund industry.

A mutual fund is a brilliant structure. Each vehicle within the structure is independent. Though various vehicles are housed under the same mutual fund umbrella, there is neither cross-support nor cross-contamination. This is unlike a bank or an insurance company where all the various assets are pooled. If there is a bad asset in a bank, it affects all its customers with little risk segregation. In the case of a mutual fund, however, it is restricted to the owners of that vehicle only—and such owners would be aware of these risks. Hence, a mutual fund offers various products based on individual risk tolerance and it avoids situations of one rotten apple spoiling all others. This structure, therefore, needs no innovation.

However, the asset management company (AMC), which manages the mutual fund, is a different animal altogether. An AMC, appointed by the trustees of the mutual fund to manage its affairs, is a combination of three separate activities. The distribution arm raises assets from investors, the fund management arm invests the assets in capital markets, and the operations arm takes care of back office activities. These three entities have different economic characteristics and when housed within a single entity, like an AMC, may breed inefficiencies.

The fund management function is akin to a profession similar to that of a medical doctor. It is highly specialised and, most importantly, loses value as volume increases. It, therefore, has diseconomies of scale. A good medical doctor can treat a reasonable number of patients; but if she is made to treat very many patients, beyond her human capacity, the quality of medical care will suffer. Similarly, a portfolio manager will see her performance deteriorate if the assets under her management increase beyond a certain threshold based on her capabilities. This is because larger sums of money are harder to compound at high rates. Size forges its own anchor.

If we now look at the distribution arm, there are probably economies of scale. The success of this arm will be based on its ability to penetrate its distribution infrastructure deeper across the country. Given the infrastructure it establishes is a fixed cost, the higher the assets it raises, the higher the efficiency it achieves. Its success will depend on its ability to harness various portfolio managers across various asset classes. It could then launch innovative products, which will help it to attract a greater share of an investor’s wallet.

The third arm is a pure operational entity and benefits significantly from scale of operations by investing in technology. Its ability to reduce the cost per rupee of asset managed for the distribution arm will be directly proportional to the number of transactions undertaken.

Hence, instead of housing all these three ‘arms’ in one entity and loading the disadvantages inherent in such a structure on the investor, the regulator can give three separate licences. These would be for investment management, distribution and operations, causing a plug and play model to emerge. A portfolio manager may be able to provide her services to various distribution firms. A distribution company will have a huge choice among various money managers and will even be able to negotiate performance-based management fees with them (subject to the overall cap on fees). It will be able to launch varied products based on different asset classes and or sectors. It will be able to get the best pricing from the operations company thereby bringing down the cost of managing money, ultimately benefitting the investor.

As India grows, there are many sectors such as infrastructure, and start-ups that are in need of capital. Each sector may not be big enough for a portfolio specialist to be part of a large AMC. Instead, a portfolio manager who specialises in a particular sector or an asset class can offer her services to many for a fee. Investors would benefit by getting access to the best portfolio managers to take care of their financial needs.

From the regulator’s perspective, investor interest is paramount. Hence, the distribution entity, which deals with investors directly, would need to be heavily regulated. The other two entities, which provide their services to the distribution entity, can be lightly regulated.

RBI is fostering innovation by encouraging the split of three core functions of the bank—deposit taking, lending and transaction processing. Similarly, if Sebi can encourage a three-way split of an AMC, it will not only bring in innovative business models but will also provide the necessary impetus to the mutual fund industry in its endeavour to take on the important task of providing capital to the corporate sector.

Huzaifa Husain is head-equities, PineBridge Investments, India.

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