Ways in which MFs can get picked by retail investors

• Posted by Sindhuri G August 28, 2012 - Filed in Business - 2,189 views

  Last fortnight saw the first steps being taken to revive the mutual fund industry. Among others, specific incentives have been provided to take mutual funds to locations beyond the top 15 cities. Despite their obvious merits—setting aside the question of distribution for a while—one wonders why investors do not choose mutual funds. I believe that the product choices are complex and overwhelming. There are too many products, too many variants within a product, and there is an overload of information thanks to exemplary disclosure practices. This results in inaction even for the most informed investors in top cities, not just the uninitiated in the hinterland. The work of leading psychologists and behavioural economists, who have examined how people make choices, can be extended to mutual funds to understand why people don't opt for them.
  
  Barry Schwartz, in his book The Paradox of Choice, argues that too much choice might lead to a decision paralysis. When there are too many choices, users tend to increase their expectations and look for a perfect fit. They face the cognitive problem of dealing with loads of information and making product comparisons. When they do choose, they worry about what they may have missed. Worse, they blame themselves for buying a wrong product, since the market place provided them with choices. The end result is that people end up making no choices.
  
  Similarly, Richard Thaler and Cass Sunstein, in their book, Nudge, recommend that including a default option that is easier to apply, even if the user does not make a conscious choice, works well. When new joinees to a retirement program were asked to 'opt in', 20% did so in the first three months, and 65% in the next 36 months. Instead, if they were asked to 'opt out', meaning they were part of the plan by default and had to make a choice only if they were to opt out, 90% joined in the first three months, moving up to 98% in the first 36 months. The users failed to make a choice in both cases, but in the latter case, it worked to their benefit.
  
  Let us consider banking products as a relatively simple parallel to highlight the things mutual funds can do to make it easier for them to be chosen by investors.
  
  First, enable easy comparison by categorising products. If investors know that they have to make a choice between comparable options, the information that they have to deal with is reduced. Every single bank offers credit cards and term deposits. Investors understand the generic category and their decision to choose between banks offering similar products is simpler. Mutual funds, on the other hand, have turned product creation into a fine art. Ironically, the categories offered to informed institutional investors are generic across funds, such as liquid and gilt funds, but the ones offered to the retail market, except for the ubiquitous FMP, come in a range of confounding names, features, styles and strategies. It is important to enable a simple comparison by retail investors with no facility for research.
  
  Second, promote product options that fit into a generic, but dominant need, before bringing in variants. Every bank has plain vanilla savings and current accounts, which cater to the generic and dominant need to maintain transactional balances for payment needs. The dominant need translates into a default choice, which leads to the beginning of a relationship with the bank. Subsequent product choices build on a basic, well-understood premise. It is tough to identify a generic and dominant product that every mutual fund investor would be happy to hold. It could have been the liquid fund, which ensures efficient utilisation of idle balances, or the equity index fund, which ensures simple exposure to equity as an asset class at a low cost. A default choice in these could have enhanced participation and offered immense benefits for both investors and funds.
  
  Third, having a prior preference before making a choice is helpful. If investors know what they are looking for, they choose a product with this need in mind. This reduces the cognitive stress in making the choice as well as the information overload. A customer approaching a bank for a home loan knows that he requires a large lump sum. Assume that the bank offers a loan which requires paying a regular interest and repaying the principal on maturity. This structure would not help the customer. He would not be able to repay the loan on maturity unless he sold the house, and that is not a preference he seeks. A bank loan structured as an EMI that enables customers to look at their loan as a percentage of regular income, facilitates their choice significantly. Many customers do not bother with the math of interest rate computation as long as they can afford the EMI. In the case of a mutual fund product, the customer's need for the product is not well-articulated in the first place.
  
  The emergence of financial planning as a framework that enables investors to define their preferences before making a choice is a welcome step. However, this is in the realm of financial advisory, not fund management. Mutual funds depend heavily on advisers to provide this preference framework to investors. Therefore, developing a professional cadre of advisers and planners is in their interest. Unless mutual funds are able to achieve that, product reach will continue to be a factor of commission-driven push, with its undesirable consequences.
  The second level of reform in the mutual fund space should focus on products and simplification of choice for investors.