Sharing the blame

Why households don't trust equity mutual funds enough

It has been 20 years now since mutual funds sponsored by private sector entities were allowed to enter the Indian market, and it is increasingly clear that the hopes that accompanied their advent have been belied. It was expected that they would aid in financial inclusion; mobilise household savings for the equity market; be taken up as a major inflation hedge by savers; and aid in the broad-basing of corporate ownership. Instead, recent years have seen savers largely desert equity mutual funds. What has gone wrong? And is there anything that can be done to reverse mutual funds' slide to irrelevance?

The problem is not just that returns to investors have consistently been disappointing. That is certainly the case, though. Nor can the state of the market since its crash in 2008 take the blame; even in the boom years before that, debt mutual funds were outperforming equity mutual funds in growth of both assets and investors. Prior to 2008, funds struggled to meet their self-defined benchmarks; since then, they have regularly underperformed even the indices. Meanwhile, direct equity investment dwarfs investment through mutual funds, revealing that it is the management of mutual funds that turns off even equity-friendly investors. This is not surprising, given the performance and efficiency of fund managers. A good gauge of the quality of human capital in mutual fund management is how index funds in India fail to match the Nifty. Elsewhere in the world, differences in returns between index funds and the index they're supposed to track - known as tracking errors - are considered unacceptable if they're over 0.3 per cent. In India, tracking errors of one per cent are common. And poor management of equity funds is combined with high costs of this management - management fees are over two per cent in terms of expense ratio on average for actively managed funds, something unheard-of in more mature fund markets.

For investors, though, the problems extend beyond high fees and low performance. It comes down to a matter of trust. Mutual funds, like insurance projects, are typically sold by distributors - and household savers have learned that their own incentives are not always solidly aligned with those of the sellers. And this is the fault, essentially, of misplaced regulation. Regulation has focused on ensuring that funds are not mis-stating their claims of future growth, on their providing "full information" to investors, and on growing "financial literacy" among investors. Unfortunately, nothing is said about what third-party sellers, including banks, state about the mutual funds on offer. And the "full information" offered to households is frequently too vast and complex for part-time investors to fathom. And, of course, financial details about schemes are usually shared with potential investors in partnership with those selling the funds in the first place, which does not overcome the problem of trust at all - frequently turning into what is practically a marketing exercise. Given the returns, therefore, the hassle for household savers is too high, especially when alternative hedges against inflation are available, such as gold or real estate. If equity mutual funds are not achieving in India what was promised 20 years ago, the fault is partly the industry's, in failing to sell itself directly and more transparently, and partly that of regulators, in not putting in place consumer-friendly systems.