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Business News/ Opinion / Disclosures begin at the door of the financial authorities
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Disclosures begin at the door of the financial authorities

Financial agencies need to do communicate better, as, often, investors become victims of this broken communication

Shyamal Banerjee/MintPremium
Shyamal Banerjee/Mint

On 6 August, the Employees’ Provident Fund Organisation (EPFO) took its first step into the stock market. After an April notification from the Ministry of Labour and Employment allowing it to invest 5-15% of all the incremental accretions into the stock market, EPFO picked the exchange-traded fund (ETF) route to do so. It hopes to have invested at least 5,000 crore by the end of the fiscal. An ETF holds a basket of stocks tracking the stock prices of companies in its portfolio and is traded on the stock exchanges. Being passive investments, they not only obviate the fund manager’s risk but also come with lower expense ratios. On an average, an active equity mutual fund comes with an expense ratio of 2.25-2.5% compared to 0.15-0.5% that ETFs charge.

EPFO picked SBI Mutual Fund and decided to invest in SBI-ETF Nifty and SBI Sensex ETF. For now, 75% of EPFO’s stock market investment will go into SBI-ETF Nifty and rest into SBI Sensex ETF. A 5,000-crore investment in the market may be a trickle right now, but given that it comes from an institution like the EPFO, which has a sticky fund base (it manages around 8.5 trillion and has an active subscriber base of at least 35 million and growing), it means a steady inflow of domestic money into markets every year. Over time, this trickle can lend stability to the markets and protect them from external shocks, something that cannot be done if foreign institutional investor (FII) inflows dominate. So, inflow of pension and insurance money is seen as a move that’s good for markets.

However, given that EPFO’s entry into the stock market was a much awaited move, the process left much to be desired. EPFO picked SBI Mutual Fund; a decision motivated by the fact that the State Bank of India (SBI) has been its banker and is also one of its five fund managers. Even as EPFO may have a relationship of trust with the largest bank, it does not by default make SBI Mutual Fund the most eligible candidate. There needs to be a process of selection, which, among other things like establishing expertise, allows for price discovery. Take the National Pension System (NPS), for instance. One of the main fund manager selection criteria was fund management fee. The lowest management fee was arrived at through an auction. But it proved to be detrimental primarily because of the huge gap between the potential and actual traction of NPS; bidders quoted rock-bottom fees in the hope that people would take to NPS in huge numbers.

A low expense ratio is good because it not only puts more money in the pockets of the investors but, in the case of passive funds, also reduces the tracking error (a measure of how closely a portfolio follows its benchmark index).

While SBI Mutual Fund reduced its expense ratio from 0.36% to 0.07%, this is not the lowest in the industry. In fact, one of the asset management companies that EPFO has employed to manage its debt funds lowered its expense ratio to 0.03% for its ETFs. So, why didn’t EPFO consider an asset management company with a lower expense ratio? According to it, SBI Mutual Fund is just a start; it would be looking at other mutual funds as well. But given the size and reach of the EPF, a transparent process to select ETFs, thereby giving subscribers the benefits of the lowest expense ratio, should have been a minimum criterion.

As markets develop, it becomes important to maintain transparency and develop communication with investors. A regulator that needs to make efforts in this direction is the Insurance Regulatory and Development Authority of India (Irdai).

In its draft amendments on 2 July on investment guidelines, Irdai oddly mandated that at least 25% of unit-linked insurance plan (Ulip) fund will be invested in central government securities (G-secs). Ulips are transparent market-linked insurance cum investment products that put the choice of investment in the hands of the investors by offering a variety of funds—from pure debt to pure equity. The draft rule not only takes that freedom away but also threatens to lower the yield since returns from G-secs are seen to be risk-free and tend to be lower than what the markets can generate. In the amendment, Irdai has not provided a rationale for such a move, especially considering that this would be a first.

So much is left to guesswork. But the only intelligent guess anyone can make is that the government is arm twisting the regulator into allowing it to use funds available with life insurers to finance its long-term plans. Draft regulations are made public for comments from the stake holders which often includes the consumers. So it’s important to first inform the stakeholders about the rationale and the need to make changes to the existing structure.

The Indian Financial Code (IFC) that seeks to give the financial industry a well-oiled modern architecture understands the importance of this communication. In the Code’s chapter 17, it is stated that a draft regulation needs to specify the objectives of the proposed regulation and the problems sought to be addressed. The draft also has to give a cost-benefit analysis of the proposed regulation (see the IFC at https://mintne.ws/1E4MFxt ). More importantly, the Code states that a regulator needs to give at least 21 days to hearing representations and then publish these along with a general account of the response of the financial agency. Irdai gave only nine days for a response.

Regulators and financial agencies need to do a better job of communicating with stakeholders as often, investors become the victim of this broken communication. Also, an informed consumer would demand better standards, which helps the cause of the regulator.

deepti.bh@livemint.com

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Published: 20 Aug 2015, 11:10 AM IST
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