Opinion | Why do equity and debt MF investors react differently?

The Indian retail equity mutual fund investor has continued to baffle commentators and policymakers by her behaviour across the previous few mega market mayhem events. Equity flows have remained net positive and the haemorrhage that a covid-19-induced market crack should have caused was clearly missing up to the end of April 2020—with some of the worst one-day falls across a few days covered in that period. Data shows that retail money in equity funds actually rose over the worst of the market crash in the three months of February, March and April 2020 and was 55% higher than the previous year same period. Systematic investment plans (SIPs) have held their flows at about ₹8,500 crore a month—there have been pauses but no dip. But the same retail investor has rushed to redeem his debt fund portfolio and flown to the safety of fixed deposits that have seen a 33% growth over the same period. What’s going on? This should have been the reverse—a rush to safety should have killed the equity funds. When commentators and policymakers put this down to quirky or eccentric investors, they make the error of looking at retail investor behaviour divorced from the marketplace in which they operate. In fact, the actions of retail investors show the robustness or flaws in the regulation that affects how firms behave in the markets and how smartly they are able to bend the rules and thereby reduce trust in the marketplace.

The equity and debt markets show this very clearly. Let’s look at market share first. The equity mutual fund market has emerged as largely retail with individuals owning almost 90% of the assets under management (AUM). The story reverses in the liquid and money market where institutions (banks, trusts, corporates, insurance companies) own just over 80% of the AUM. In the longer-tenor debt funds, the asset mix is more equal—with retail owning just over 40% of the AUM, the bulk is still institutional. This market share has meant that the market regulator has been harder on the equity market rules than those for the debt simply because that part of the market is retail heavy. Starting from the removal of the NFO (new fund offer) expense charge of 6% and the front load that was causing investor churning to banning of upfronting of trail and fund categorization, the incremental regulatory tightening has given a marketplace that is much safer than before. Most of the conflicts of interests are now taken care of, though there will always be the red light violator. I am not saying there is no mis-selling or churning. Of course it is there, but the institutional connivance between mutual funds and sellers is now restricted to banks and a few other sharp shooters, rather than an industry standard. Smaller ticket equity investors are also working with IFAs and financial planners who have done well by them in terms of education about how equity works.

The story in the debt part of the market is very different because of several reasons in regulation and firm behaviour. One part of the story has to do with risk and how it impacts this category of products. The risk comes from both a change in interest rates (milder risk), from the quality of paper held by the fund (higher risk) and the liquidity of the market (death risk for poor quality paper). Read more.

Investors rely on credit rating agencies that indicate the relative safety of the bonds held by the mutual funds. But credit rating agencies globally have been found guilty of lazy and compromised ratings, late reactions to changing situations and finally hiding behind the ratings being an “editorial opinion” to escape legal actions. The regulator has continued to tighten rules around rating agencies as well and in a global first, India has made credit rating agencies responsible for their ratings (read).

On one side is a difficult-to-regulate market and on the other are fund houses whose quest for institutional assets that funnel money towards schemes displaying higher returns have taken the rules and stretched them like an elastic band. For example, the sleight of hand used to classify a long-term bond as a short-term one. Read this superb piece by Deepak Shenoy (CEO at Capitalmind Wealth) to see how this was done. Over the years, fund houses have found loopholes (dividend stripping), bent rules (buying promoter shares through debt funds), stretched them (inter-scheme transfers) in this part of the market with the regulator always a few steps behind. Firms have also taken to hand wringing and hair pulling at the doorstep of the regulator, the use of friendly media to run campaigns, the door-bell ringing at North Block each time tougher debt market rules are discussed by the regulator. The technique they have deployed, of if-you-push-me-so-hard-I-will-go-ahead-and-fail, is straight out of the tool kit of banks who have used it to successfully avoid consumer protection for years.

Retail investor behaviour is reflective of the distrust of the debt part of the market. If the mutual fund industry and the regulator want retail investors to have the same faith and understanding in debt as they display in equity, they need clearer rules from the regulator and better behaviour from the fund houses.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation