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.