Bank churning needs RBI action

Also Read Monika Halan’s earlier columns

Let’s understand this thing called churning and why it harms you. And why it is allowed to continue. Churning, as described by the US Securities and Exchange Commission, is the excessive buying and selling of securities in the investor’s account by his broker, for the purpose of generating commissions and without regard to the customer’s investment objectives. Or in simpler words, it is when your broker or agent nudges you to buy and sell frequently in order to make the commission that comes with every trade. Churning, in most mature markets, is a violation of rules.

There are conditions under which churning is a most effective way for brokers to milk their uneducated clients (the smart ones call the shots and just get the brokers to do what they say). One: it needs a product that the retail mass is familiar with and comes without a lock-in. Mass sale of, say, currency futures is not possible since the product is unknown and will not be bought by the mass retail investor. But mutual funds have achieved a brand recall with the average urban “banked" individual and they come without an investment lock-in period (unlike a unit-linked insurance plan that now comes with a five year lock-in), though there is an exit load sitting at the end of some equity funds. But then those details can be forgotten when communicating with the investor.

Two: a transaction fee that can be collected painlessly and with minimum investor discomfort. Bank customers who also buy funds through their bank often do not see the transaction fee tagged onto each mutual fund purchase. Though the charge is legitimate (the capital market regulator has banned loads, not a transaction fee), its use to generate churning income is not. That makes up one part of the banks’ income from each sale of the fund. The other part comes from the fund house itself that shares about 75 basis points out of its annual 1.25% fee on the assets under management (AUM) with the bank and distribution house. Rough calculations say that just this has earned banks ₹ 110 crore in the past one year. And we are not counting transaction fees and trail commissions (keep investor for a year, earn trail, then churn).

Three: a rising market. The retail investor looks at round numbers and not nuanced portfolio return figures. She puts in 100 and waits for it to become 115-120 at the end of the year. A rising market ensures that in most cases it does. What she does not know is that the market has actually done better and, even in an index fund, her money would have been at 140 or if she stayed in a well-managed fund, even 150 or 160.

All three conditions have been in place for the past one year, leading to the story of banks and large distributors churning their retail mutual fund investors. The noise around the net outflow from equity funds caused by no-loads is hiding the true story: of money that came in but was pushed out again. More than ₹ 42,000 crore came into equity funds in the last one year. Why did it come in? Who sold these funds and why if there are no loads? Look at the data break up and the story emerges. About ₹ 14,000 crore was invested through the banking channel and almost ₹ 16,000 crore was sold off. Investors put in another ₹ 13,000 crore through national distributors, who sold almost ₹ 15,000 crore (remember, a rising market takes the assets under management up, making it possible to have a higher outflow over inflow figure, apart from the fact that earlier investments could also have got redeemed). But investors who go directly to the fund house invested about ₹ 4,000 crore and sold ₹ 3,000 crore—a net inflow of about ₹ 1,000 crore. The data on the behaviour of the retail versus high net worth investor is even more telling. Retail investors (most of whom rely on the advice of banks and distributors) invested ₹ 16,000 crore and redeemed ₹ 18,000 crore, HNIs have invested ₹ 16,000 crore and sold ₹ 15,000 crore.

The biggest churn has happened through the banking channel and unfortunately the banking regulator, the Reserve Bank of India (RBI) has been ignoring the issue of bank branches being used as mis-selling and churn stations. Many interactions with senior RBI officers have shown a hands-over-ears approach. Could it be that the mandate of the regulator is to manage the macroeconomic picture and prevent bank failure and clearly not investor protection? Retail investors who use bank branches to transact on their investments, it seems, are a minuscule issue for RBI. If this is true, then, this regulatory function for the safety of retail investors needs to be taken away from RBI and entrusted to another entity.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and can be reached at expenseaccount@livemint.com