Modern finance, based on securities markets, is a great enterprise when compared with the old banking-oriented finance. As Merton Miller says, banking is a disaster-prone 19th century industry. Emphasising the securities markets avoids the periodic disasters with banks that seem to afflict most countries, particularly the countries which are unable to close down a weak bank before it's insolvent.
From this framework, there is much to like about mutual funds and `defined contribution' pensions: there is no leverage, all assets are marked to market every day, if a money manager goes bust it's easy to replace him with a new manager since customer assets are not comingled onto the money manager's balance sheet, and all losses are borne directly on the balance sheets of households.
The one bad thing with this happy picture is: the fees and expenses that customers suffer. I am unable to fully comprehend why, but customers simply do not seem to understand how damaging the fees and expenses of their fund manager are. For a normal product such as a refrigerator, paying more generally gets you a better product. But that isn't true for fund management, and customers just don't seem to see that.
Cellphone calling plans are plagued with an attempt to obfuscate customers and make it difficult to understand where you will get socked with charges. But atleast in the end, the customer of the cellphone clearly understands two things: He understands the call quality and he understands the number that he writes on a cheque every month. With fund management, these two things don't happen! The customer doesn't understand what "call quality" he is getting. And the customer doesn't know what number is on the cheque he is writing every month to the fund manager.
I believe there is a serious market failure taking place here. In India, the commission model has come to dominate, where agents sell fund products to customers and collect a fee. There is competition between finance companies and competition between insurance versus mutual funds, each trying to gain market share by giving the agent a bigger discount. One foreign bank has an internal target of obtaining 12% of the wealth out of each customer of theirs per year. This, in a country where the expected return on the equity index is probably 13%. The worst excesses of this kind are by the insurance companies. Of the Rs.60,000 crore that went into insurance companies in 2004, Rs.6,000 crore (or 10%) turned around and went back as kickback to agents! But the mutual funds are now determined to match the insurance companies in this racket. Recently, SBI Mutual Fund reached a new low by paying 7% to the agent. So when the customer puts in Rs.100, only Rs.93 gets invested.
Monika Halan has a good article on this problem in today's Indian Express. What can you do different at a personal level? One big thing that comes to mind is: Buy Exchange Traded Funds (ETFs) on the exchange screen. The only direct fee that you pay is brokerage, which is a competitive market and really cheap. You do need a tight bid-offer spread on the screen, but that's often available.
In the long run, will the situation get sorted out? Competition between agents could drive down their fees. Customers could wise up, start looking at fees and expenses, understand that when they write a check for Rs.10,000, the agent is getting Rs.700, and favour index funds sold over the net without commissions in the picture. But all this could take many decades. Can we do better? The design features of the New Pension System are focused on addressing some of these problems with the market for fund management products. You might find my paper on the Indian pension reforms useful.