Are large investors always smart cookies and small investors babes in the woods? The Securities Exchange Board of India (SEBI) seems to think so, going by its recent market interventions to shield retail investors from risky financial products. Earlier this month, acting on reports of mis-selling of YES Bank’s AT-1 bonds to homemakers and retirees, SEBI decided to bar the sale of all bank AT-1 bonds to individuals. Only qualified institutional buyers such as mutual funds, insurance companies and pension funds can now buy these bonds. The minimum trading lot in the secondary market has been hiked to ?1 crore.
In August, after a spurt in demat account openings that hinted at new investors joining the bull party, SEBI introduced upfront margins for cash trades in stocks. These rules place an absolute cap on the total leverage that even seasoned traders can take in their cash market positions.
In 2019, after reports emerged of investors in smaller cities and towns taking to Portfolio Management Schemes (PMS) in droves, SEBI decided to hike the minimum investment limit for PMS from ?25 lakh to ?50 lakh, shrinking the universe of investors who can buy them.
Recently, SEBI made further tweaks to its mandated investment pattern of multi-cap funds, following its MF re-categorisation exercise. In 2018, to simplify choices for first-time investors in MFs, it mandated an industry-wide reclassification which dictated that Indian AMCs offer only 36 types of schemes on their menu and stick to minimum quotas for large-, mid- and small-cap stocks in equity funds.
Each of these regulatory measures is unexceptionable from the point of view of protecting newbie investors from costly missteps in stocks, bonds or MFs. But they also have the unintended consequence of restricting choices or returns for seasoned investors, or impeding market development.
Take the AT-1 bond directive, for instance. While perpetual bonds that can skip coupons or write down capital may be quite unsuitable for folks looking for capital safety or regular income, they are quite a good fit for HNIs (high net worth investors) fishing for high-yield instruments in India’s shallow bond market. For banks looking to raise capital through this route, the blanket ban can prove a constraint.
Similarly, short-term trading in stocks may be a loss-making activity for many retail folk who dabble in it. But there are also a fair number of retail traders who, after blowing up their trading accounts a few times, have developed successful trading systems with sound risk-management practices that has allowed them to take up trading as a full-time profession.
It is such traders who contribute much of the market liquidity and ensure that long-term investors have ready counter-parties for their trades. Whether the MF re-categorisation exercise has simplified choices for first-time investors is open to debate, but it has certainly made life more difficult for seasoned investors who go by a scheme’s mandate and track record. With AMCs resorting to drastic changes in the names, mandates and investment patterns of their schemes so that they didn’t have to shutter them, past records for many schemes have turned irrelevant. Requiring fund managers to stick to prescribed large/mid/small-cap quotas in equity schemes reduces the room for tactical calls that contribute alpha.
This suggests that restricting available choices or changing the ground rules for an entire industry are not optimal solutions to the problem of some retail investors buying into the wrong products.
Net worth — a flawed measure
Another approach that global regulators have tried is to erect entry barriers against smaller investors in products that they deem too complex or risky, through net worth criteria.
SEBI, for instance, has watertight regulations in place, with elaborate disclosures, for products that it considers suitable for small investors such as IPOs, equities, mutual funds and NCDs. For vehicles that it considers to be too complex or risky for the small guy, it makes do with light-tough regulations and sets a high investment threshold so that only HNIs can participate. Examples here are the ?50 lakh minimum ticket size for PMS, ?1 crore for alternative investment funds, a similar lot size for AT-1 bonds and the ?2 crore net worth requirement for angel funds.
But there are three problems with the net worth-based approach to investor protection. One, it presumes that HNIs are automatically more knowledgeable about financial markets and risk management while less wealthy folks, as a class, are ignorant of such matters. In reality though, Indian markets have been witness to many scams — from emu-rearing and timeshares to the NSEL scandal — where HNIs were taken for a royal ride by sharp operators promising fabulous returns from outlandish schemes. Clearly, the ability to evaluate complex products or grasp the relationship between risk and return depends far more on one’s financial awareness and reading habits, than on the number of zeros in one’s net worth.
Two, less wealthy individuals or young investors have a far greater need to take a chance with risky assets such as equities to build wealth, than HNIs already sitting on piles of money. Keeping out low-net-worth folks who have a sound grasp of the financial markets from share trading, derivatives, PMS or AIF schemes, leads to an iniquitous situation where the rich have every opportunity to get richer, while those aspiring to wealth find the opportunity barred to them, despite being qualified in every other respect. There’s no harm in investors with limited net worth buying AT-1 bonds or PMS schemes if they can understand and manage the resulting risks through prudent allocations.
Three, successful traders and investors will testify that acquiring expertise on investing always entails paying a tuition fee to Mr Market, by making mistakes and learning from them. Stepping in to protect retail folks from the consequences of their own actions every time they stumble, can prove an impediment to their evolution into seasoned investors.
This is why SEBI must avoid the temptation to hover like an anxious parent over small investors and devise ways to allow even non-wealthy folks with requisite financial knowledge to invest in risky or complex products if they desire it.
One way to do this is to adopt an ‘accredited investor’ framework like the one prevailing in the US markets. In August this year, the US SEC widened its definition of ‘accredited investor’ to allow individuals who had passed certain qualifying exams, to participate in private markets. SEBI too can consider a framework that allows all domestic individuals, whether wealthy or otherwise, to acquire accreditation through an exam that will qualify them to dabble in short-term trading or derivatives, PMS schemes, AT-1 bonds or hedge funds, if they so wish. To make it doubly clear to such folks that they are stepping onto risky territory, SEBI can insist on a written opt-in into such products through a signed declaration.
Such a regime may also allow SEBI to write regulations that strike a better balance between its investor protection and market development mandate, without leaning too much in favour of the former.
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