Of exit loads, fund houses and distributors - 2

Yesterday...
All my troubles seemed so far away,
Now it looks as though they're here to stay,
Oh, I believe in yesterday...

(Yesterday – The Beatles)

This iconic song pretty much sums up the mood among several mutual fund distributors. For distributors habituated to attractive compensation structures and easy money, the new-look mutual fund industry has come as a rude shock. In one deft move (scrapping entry loads), the regulator changed the rules of the game. Further, the provision for uniform exit loads plugged the loophole that some would have liked to exploit.

Newspaper reports suggest that fund houses’ pleas to roll back/modify the entry load provision has been rejected by SEBI. Some fund houses have decided to compensate distributors by paying them an upfront commission in any case. Distributors on their part are tweaking their business models. Fee structures are being charted out; new value-add offerings are being introduced. Terms like ‘unbiased’, ‘independent’ and ‘research-driven’ are now liberally used in communication. Clearly, the mutual fund industry is in unchartered territory and ‘wait and watch’ is the new mantra.

Despite the gloomy picture being painted by most, it would be safe to state that the scenario isn’t as bad as it is made out to be. In fact, things could become markedly better for all the participants i.e. investors, fund houses and distributors.

Conventionally, distributors have worked on the ‘assets under management’ model i.e. more investments their investors made, higher was their pay-off. Broadly speaking, the latter came from the entry load, the trail commission and ancillary compensation/benefits provided by fund houses. While entry loads have been done away with, distributors can now demand compensation from investors directly. Also, unlike loads, this compensation is not regulated. It has been left to be mutually determined by the investor and the distributor.

Distributors argue that investors are unlikely to be willing to compensate them. There is some merit in that argument. Investors habituated to filling mutual fund forms and writing cheques for the investment amount, might resist the new arrangement initially. However, once they are convinced of the value that the distributor adds to the investment process, the resistance will subside.

The importance of quality advice and service cannot be overstated. The distributor has a vital role to play in aiding the investor achieve his financial goals. Making an investment plan, successfully managing and tracking an investment portfolio are no mean tasks. And once the distributor effectively communicates how his services can aid the investor, there’s no reason for the investor not to come on board.

Sure, distributors who fail to add value and work in the investor’s best interests might see their business dwindle. But that would only be a fair and natural consequence.

From the fund houses’ perspective, it’s an opportunity to have access to serious, long-term money. It isn’t entirely uncommon to see ill-advised investors invest monies simply to ride the rising markets. With quality advice being made available to investors, we could see the rise of a breed of informed investors who are willing to stay invested for the long-haul. Investors who don’t panic when markets experience downturns; instead they see the same as an opportunity to make investments at attractive prices. Now wouldn’t fund houses love to have such investors investing in their funds? Also, it would be fair to assume that fund houses will handsomely compensate distributors facilitating serious investors and long-term monies, for their efforts.

As for the investor, it's options galore. Some distributors will operate on the ‘transaction’ model i.e. use technology to offer investors a low-cost platform for making investments, others will bank on providing quality advice and then there will be those whose USP will be personalised service. In most cases, there will be an overlap. From the investor’s perspective, the importance of being aligned with the right distributor has never been higher. Investors will have to thoroughly evaluate the proposition offered by each distributor and select the one that best works for them.

For instance, if a distributor boasts of his research set-up, quiz him about the same, the size of his team and their experience. If a distributor claims to be independent, enquire how he ensures that his independence is not compromised with. If ‘low-cost investing’ is the platform on offer, find out how the same compares with other distributors. The onus to conduct a thorough due diligence and make an appropriate choice lies with the investor.

It won’t be surprising if investors choose to be associated with multiple distributors; for instance, the advice could be sourced from one distributor and transactions made with another.

As mentioned earlier, the mutual fund industry and its participants are in unchartered industry. However, despite what the naysayers would want you to believe, it need not be all gloomy. Remember the adage about – it’s not the cards you are dealt, but how you play them. The ‘how you play them’ part could hold the key for the mutual fund industry, going forward.

Here comes the sun,
Here comes the sun,
And I say it's all right,
Little darling, it's been a long cold lonely winter,
Little darling, it feels like years since it's been here,
Here comes the sun, here comes the sun,
And I say it's all right...

(Here comes the sun - The Beatles)

Of exit loads, fund houses and distributors - 1

The line, it is drawn, the curse, it is cast
The slow one now, will later be fast
As the present now, will later be past
The order is rapidly fading
And the first one now, will later be last
For the times, they are a changing

(The Times They Are A-Changin'- Bob Dylan)

To say that times are changing for the mutual fund industry would be stating the obvious. In all fairness, not many anticipated the same; perhaps, some are still struggling to come to terms with it. Nonetheless, change is here and it’s here to stay.

Retail investors, who have conventionally been at the receiving end of whims and fancies of fund houses and distributors alike, have become an empowered lot. Thanks to the regulator’s intervention, a level playing field has been created. Fund houses had barely recovered from the SEBI regulation abolishing entry loads, and now the regulator has taken aim at exit loads. SEBI has ruled that fund houses can no longer charge differential exit loads based on the investment amount.

First, let’s discuss what an exit load is. Simply put, it is a charge/penalty levied on an investor for exiting an investment before a stipulated period. For instance, open-ended equity funds may require investors to be invested for at least 12 months, in order to avoid paying an exit load. The rationale for the same is quite simple. Each fund has a distinct nature and it should attract monies for a commensurate time frame. Equity funds typically require investors to have a much longer investment horizon vis-a-vis say a liquid fund. Now an investor, who gets invested in an equity fund for a shorter time frame, might on exit, force the fund manager’s hand, and in the process hurt the prospects of long-term investors in the fund. Hence, the exit load which acts a deterrent for erring investors.

However, fund houses chose to tweak the exit load provision to accommodate big-ticket investors like high networth individuals (HNI) and corporates. This was done by creating differential exit loads based on the investment amount. For example, a retail investor investing Rs 5,000 was charged an exit load of 1.00% for liquidating his investment before 1 year from the date of investment; however, an HNI investing Rs 5 crores (Rs 50 million) in the same fund was outside the purview of exit loads. If you are wondering why fund houses perpetuated such disparity, the answer is pretty straightforward. A higher asset size equals higher revenue for the fund house. Typically, an HNI/corporate investor brings in a substantial amount of money i.e. he significantly contributes to the fund house’s asset size and revenues in turn. Hence, fund houses' willingness to ‘accommodate’ them.

There are some who justified differential entry and exit loads on the grounds that bulk transactions are subsidised in all walks of life. Sadly, the difference between buying grocery at a supermarket and investing in a mutual fund is lost on such individuals.

Thanks to SEBI, fund houses will now have to shed their prejudices and treat all investors alike going forward.

The reason for entry loads coming under focus at this stage is quite interesting. This phenomenon can be traced to the SEBI directive abolishing entry loads. Therein, the regulator had stated that 1.00% of the monies collected as exit loads can be utilised by fund houses to compensate distributors and meet marketing and distribution expenses.

Expectedly, fund houses saw an opportunity to aid distributors by implementing a stiffer exit load structure. The latter meant that either investors would pay higher exit loads or be required to stay invested for longer (vis-a-vis the past) to avoid paying an exit load.

Fund houses would like us to believe that the move to hike exit loads was only intended at promoting long-term investing. And perhaps it was. But then, isn’t it fair that all investors (irrespective of the investment size) be exposed to the virtues of long-term investing?

Had differential exit loads not been scrapped, the new (read stiffer) exit loads would have been borne by retail investors, since investments made by HNIs and corporates were largely outside the purview of exit loads in the earlier regime. SEBI has ensured that the exit load burden (and thereby the onus to indirectly compensate distributors) is equally borne by all investors.

Clearly, the excesses in the mutual fund industry were not lost on the regulator who has decided to champion the investor’s cause. The abolition of entry loads and differential exit loads are among several changes that will have a lasting impact on the mutual fund industry.

Any discussion on the mutual fund industry’s metamorphosis cannot be complete without deliberating on distributors. Over the years, the importance of distributors as a link between fund houses and investors, and more importantly as fund houses’ allies has grown by leaps and bounds. And now, the distribution mechanism is all set for a major overhaul as well. More on that in the concluding part of this article.