11 July 2012

To charge or not to charge - mutual funds and entry load

I have a piece in today's Financial Express on the possible re-introduction of entry load on mutual fund investors. Here is the piece:

To charge or not to charge, that is the question. So said the b(o)ard. The only question being asked these days in the mutual fund industry is whether the so-called entry load should be re-introduced after being banned by the Securities and Exchange Board of India (Sebi) in 2009. This has achieved some further prominence with the finance ministry taking a view on the subject of entry loads—if press reports are to be believed. Our new finance minister has also made the right noises about the revival of mutual funds.

To step back, the market regulator Sebi banned the imposition of a fee which is charged from investors every time they purchase a mutual fund security. This charge, also known as a load, is undertaken at the time of purchase and is thus called ‘entry’ load. A similar charge when a sale occurs within a particular period of purchase, say one year of purchase, is known predictably, as an exit load. These loads are essentially expenses of the fund which go to the top line of the asset management company (AMC) which manages the fund.

The other important entity involved is the distributor of mutual funds. The distributor is the elephant in the room and the sale of mutual fund products happens because of the ‘push’ effort of the distributor. A distributor can be an individual or can be a large corporate entity or even a bank. Banks typically have great low cost, high impact distribution networks as they can leverage their existing branch network and they can train existing employees to distribute financial products. Equally important, the bank is where the money is and often quick investment decisions are made when a depositor visits a branch.

Given the critical importance of the distributor to the industry—after all, they get the investor through the door—the AMC does whatever it can to woo the distributor. The world of financial incentives means that the distributor often ends up selling the product that has the juiciest margins rather than the most appropriate one.

Because of a lot of churning which occurred i.e. buy, sell and again buy, sell transactions in quick succession, the purpose of which was to make the most commission out of the investor, Sebi has been cracking down on both the mutual fund industry and on the distributors. This it could have achieved in one of two ways. First, take enforcement action against the persons who were committing the churning and thus send a signal down the industry that churning is indeed seen as fraud and will be stamped out. When Sebi was drafting the anti-fraud provisions, it clearly had envisaged churning of portfolios to be an act of fraud. This intent is clear from the text of Sebi’s FUTP Regulations—regulations relating to Fraudulent and Unfair Trade Practices. The second option was to virtually ban entry loads and also to reduce the launch of hundreds of new fund schemes by AMCs of mutual funds to create the market for churning by distributors.

Sebi chose the second option. It chose to ban entry loads—subsequently allowing a flat charge of R100 or R150 to be charged directly by the distributor. Sebi also came down heavily on funds which were creating ‘IPOs’ of funds where distributors kept selling and then buying identical funds of the same fund house with the same investment profile only to get another cut of the entry load. I have seen this being done to a client where a large bank under its ‘wealth management’ scheme churned out upwards of 30% of the portfolio through rapid sales and purchases of identical products through several years. This kind of behaviour created a market where investors would ultimately have lost confidence in the product and perhaps in the equity market itself.

Though Sebi took the easier structural route to restrict harm to investors, the move had unintended consequences. The distributors still made what is known as trail commissions from the AMC’s income, but the income was dramatically reduced, particularly at the front end. This meant that the distributors of financial products ended up selling other equity financial products, which had even juicier margins of up to 30% (Ulips, which are investment products with a small insurance cover attached) as opposed to a 1% or 2% entry load on mutual funds. With the abandonment of mutual funds being sold by distributors, the market has been consistently shrinking.

Meanwhile, the market for the alternative investment products from the insurance stable too has virtually died because the investors realised that every R100 put in gave them a negative 30% return within a day and with the markets that we have, many had lost over half their capital even after holding for five years or more. The two extreme outcomes have resulted in equity investors abandoning all equity financial products though for two opposite reasons.

While Sebi is rightly concerned about investors being cheated and foisted with loads—often being sold a product simply for the load attached to it, it does need to move away from the ban on entry loads and permit a small entry load, say with a cap of 0.25%. This it should combine with enforcement action against people who churn investor portfolios. The current flat charge of R100 or R150 in fact imposes a very high burden on the smallest investors as it is regressive. The person investing R1,00,000 pays only a 0.1% charge, but the R10,000 investor pays a 1% charge on her investment. To minimise churning and maximise transparency, this charge can be collected by way of a separate cheque.

No comments: