A couple of weeks ago, at the mutual fund industry’s annual conference, SEBI chief UK Sinha caused a flutter by commenting on the poor performance of a large number of equity mutual funds. Specifically, the regulatory head said that there were nine AMCs where more than half the schemes had generated less returns than their benchmarks over a period of three years.
The remarks caused consternation among AMC executives because there no one could remember any regulator ever having commented about the investment performance of funds. As far as everyone in the fund industry understood it, this is the way things worked: The regulator looks after regulations, systemic risk and other issues like that. How much return a fund makes on investments is something that concern only investors. Basically, the regulator stands by the investor’s side and guards him by making sure that everyone who deals with the investor is kept honest.
Under this arrangement, funds are free to lose as much of the investor’s money as they like as long as they do it honestly while following all relevant regulations. The regulations only seek to prevent malfeasance without being concerned with incompetence. Or to put it in a different way, crooks are not allowed but fools are acceptable.
Poor performance is best detected and punished by market forces in the form of investors ignoring laggard funds and fund houses. By and large, this works. Funds and fund houses that perform poorly do get fewer investors and are smaller. However, there are exceptions. There are fund houses that perform badly but make a good living on the strength of past performance and strong distributions networks.
Despite all this, the regulator’s public expression of concern serves a purpose, especially because the SEBI chief talked about performance relative to benchmarks. For one, it draws public attention to the fact that mutual funds’ main job is to outperform their benchmark indices and if some AMCs consistently fail to do so, then someone is noticing.