The financial sector in India has been relatively ignored by the policy makers, mostly on the grounds that it couldn’t possibly be that important. But no more. Financial sector developments – in the FX, debt and stock markets – are now the driver with policy-makers (including such renowned ones like Mr. Greenspan) often relegated to back-seat driver status. But while the rest of the developing and developed world is allowing competition to flourish, we in India are doing the opposite i.e. encouraging protection, and bad performance that accompanies the acts of the protected.

There is no question of competition in the FX and debt markets since these two markets are controlled by the Ministry of Finance. And in the remaining market, equities, protection is a substitute for regulated competition. In "Where have all the profits gone" (Economic Times, Feb. 1, 2000) I documented how investors in mutual funds were being short-changed by receiving substantially lower profits than they were "entitled" to. For the period, 1997 to 1999, only 2 (out of 80) public sector mutual funds outperformed the Fools Index (especially constructed because the major indices, like Sensex, were more senseless than sensible) and only 7 out of 38 high-flying FII's were able to do the same. This article, entitled "Gone to markets, everyone" documents how everyone, excepting the small investor, is deriving "rents" from the system. It is fervently hoped that there will not be an occasion to write an article entitled "When will they ever learn" a few months hence.

Lack of performance by mutual funds (i.e. obtaining returns significantly lower than a benchmark) can only be due to some combination of the following: incompetence, front-running/warehousing, and lack of competition. The first one is unlikely - if anything, the fund-managers are too competent! The second and third are the likely culprits. How can the markets be made more responsive to the needs of the small investor? By increasing competition.  

Front-running and warehousing: There are easier, much simpler ways of becoming rich in the stock-market than the old-fashioned "fools" way of making money (by earning it). The easiest method is for the brokers and the fund managers to jointly manage fund inflows. Let us go through what happens to Sita's money as she opens an account with mutual fund X. Sita (and 1000 multiples of her) deposits Rs. 10,000 with Fund X. The fund manager, Mr. X, asks his friendly broker, Mr. XX, to buy Rs. 1 crore worth of Infosys stock before Sitas' money is ready for use by the fund. This is called "warehousing"; when the price goes up, the broker sells the stock to Fund X for a no-brainer large profit, which is then shared, between the broker and fund manager. Front-running operates in the same manner, except Mr. X does not necessarily share in the spoils of the broker. In this instance, the broker knows that the fund manager is going to buy, so he buys it first.

How is Sita affected by all this? By achieving a lower rate of return on her investment since she actually buys at a higher price due to "financial intermediation". But is it not the case that several funds, finally!, were able to out-perform the Sensex in 1999 ? Yes, but as detailed in "Where have all the profits gone ?", the construction of the Sensex is manipulated to be senseless. And the above discussion documents the political economy of why it will remain so. The exchange brokers would surely like to have an unrepresentative index which the fund manager/broker can out-perform so that Sita is happy with the illusion that her monies are being well handled.

What can be done to bring about fair returns (up or down) to small investors? One method is to prohibit brokers from buying and selling shares on their own accounts, a practice followed by countries that do more about corporate governance and talk less about it - such as the USA. (In India, we let brokers buy a stake in asset management companies!) No code of governance is imposed by the Securities and Exchange Commission in the US; instead, it implements conflict of interest rules.

Front-running in the US is minimal, and profits from warehousing are non-existent since the fund manager must face the wrath of Sita if he under-performs a benchmark. If a fund-manager underperforms, the investors leave to go elsewhere in the flourishing and well developed market. Serving the needs of 50 million investors, there are more than six thousand funds in the US. In India, the needs of 30 million investors are catered to by less than 500 funds owned by, count them, 39 firms. In the US, just the firms whose name begins with an A outnumber all the 39 firms licensed by SEBI to profit from fund management.

There is another method by which competition is ensured in the US - it is by allowing small boutique fund managers to operate. In India, such licensed fund managers total 21; no typo there, just 21. Why so few? Because each boutique non mutual fund manager has to pay a fee of Rs. 250,000 a year. In the US, such managers are in the thousands, and the fee is less than Rs. 20,000 a year. The licensing on the part of the regulator, accompanied by the senseless and extortionary fee means that under-ground fund management flourishes. And who are the underground managers - why, the brokers themselves who can "guarantee" profits to their clients on the basis of front-running. And the Kafka circle is complete.

What are second-generation reformers doing ? Wait and see. But such wannabe reformers may want to investigate why they pass no-taxation laws for rich mutual funds, foreign investors, and NRI's so that the only people paying taxes on capital gains in India, and that too at a 33 percent rate, are the small investors and small fund managers; why they make warehousing and front-running legal; and why they do not allow competition in financial markets.