Introduce variable entry load model

Written by Rajiv Deep Bajaj | Updated: Aug 31 2007, 04:45am hrs
The Sebi proposal to waive entry load for direct investors in Mutual Funds (MFs) has taken most industry players by surprise. Neither, the distributors nor the MFs had any inkling of such a move. It is believed that this move has been necessitated by representations from a set of investors who would like to invest in MFs directly to save on entry loads and thereby lower their cost of purchase of MFs.

Before we analyse the impact of this move on the industry, we have to first see what role the entry load play in MF distribution. One is obvious that it is used to remunerate distributors in the form of brokerage which is their main source of income given that fee-based advice models are virtually non-existent in India. The second role of entry loads, which is not popularly known, is that MFs are allowed to use entry loads to fund their selling and distribution expenses. Hence, several expenses for expanding distribution reach are funded through entry loads. What is the possible impact of this move on MFs' retail penetration MFs are today sold in more than 800 cities and towns of India, thanks to the wide array of distribution channels like public and private sector banks, national and regional distribution chains and independent financial advisers (IFAs), making the MF distribution community 70,000-strong pan India.

What has been the role of these distributors in expanding the market The proof is in the pudding, the Equity Mutual Fund AUM has been growing at 50-60% per annum and has now reached a remarkable Rs 1,25,000 crore. The share of retail household savings invested in capital markets has gone up from 2% to an estimated 4-5% in the last five years. The number of MF folios has gone up by a whopping figure of 1 crore to cross the 3 crore level between 2005 and 2007. This is no small achievement for an industry, which has gained momentum only in the last 10 years. Distributors have played an important role in expanding reach of MFs in every nook and corner of India. Distributors have also played a crucial role in investor education.

This one move can potentially rock the apple cart and derail the momentum of MFs' retail penetration. Waiver of entry loads for direct MF investments may benefit a small constituency of cost-conscious investors but it will generally make MF distribution unattractive for many segments of distributors and may push them towards other financial products like Life Insurance and secondary market. This will also upset MFs' growth trajectory.

Will MFs be able to replicate the distribution spread of all banks, distribution houses and IFAs put together Even if some try to, will they be able to foot the bills of a retail network without charging entry loads The scale and scope of Indian markets is totally unique in itself, here we have NFOs getting response from 300 towns with applications as small as Rs 3,000. Can we imagine a similar level of penetration in China where funds are being sold in 8-10 big cities.

Now the most important point: is this proposal really in the investor's best interest I have my doubts, the reason being that MFs would never be able to directly give the after sales service required by investors post initial investment. The role of MFs is to build research, develop fund management expertise and invest investors' money as per given mandate. Nowhere in the world do MFs have an extensive direct distribution network of their own. They usually rely on independent distributors for raising money and primarily focus on giving training and marketing support to their distribution partners who serve as the direct interface with investors.

Some exceptions exist like Vanguard in US, a large Mutual Fund House that directly deals with investors offering them no load funds. But an important point to be noted here is that Vanguard has its assets primarily in simple products like Index Funds, which needs limited advice. Globally, direct selling model has not succeeded and some of these MFs are now reverting to third party distribution to sell their products at lower cost. Even in India some new funds have tried the direct selling model but with limited success.

There is an important point to be understood here. There is a big difference between waiver of entry load for direct investors in MFs vis-a-vis introducing the concept of no load funds. The former is tantamount to disintermediation and puts distributors and financial advisers in a position of disadvantage compared to those investing directly in MFs. This is akin to pharma companies selling drugs without appointing stockists/chemists, directly to consumers. Disintermediation will shrink the market in India back to 10-12 major cities and high net worth investors as MFs will not have the will to set up their offices in smaller towns to serve a Rs 3,000 investor.

On the other hand, introduction of no load funds could add another dimension to MF industry and would lead to the birth of a new breed of fee-based financial advisers. This model is already prevalent in the US where investors can negotiate the entry load with distributors and the same is transparently mentioned in the application form and account statement.

So depending on investors' perceived value of advice/service he is getting from distributor, the entry load can be negotiated anywhere between 0 and 5% as per market practice. In this scenario, many distributors offer 'No Load' plans to investors and are compensated mainly by ongoing trail fees. This model allows all types of distribution channels to co-exist and flourish, from discount brokers to high end advisors. The main beneficiary here is the investor who gets a choice of multiple service models. A graded scale where different people pay for different levels of service. MFs in India so far works on a uniform load structure to lend simplicity from a mass scale operations point of view. The graded structure though complicated to implement will help regulators achieve the objective of lowering the cost of purchase for sophisticated investors.

The proposal to waive entry loads for direct investors will come as a double whammy for distributors who were four years ago debarred by Sebi regulations from offering rebates/ passbacks to investors out of their brokerage earned. If Rebates were legal, then distributors would at least have an option to compensate investors who are looking for lower charges for investing in MFs as per current proposal. In fact, Rebates (if legalised) can be a way of reducing investors costs of buying a MF. In some markets around the world, the broker and investor negotiate the Rebate out of the entry load and the same is transparently paid to investor in the form of additional units allotted by the Fund. This entire arrangement is transparently captured on the application form itself. The irony of this proposal is that the very stakeholder for whom it has been mooted may turn out to be the loser in the end. The retail investor is the backbone of our financial system. He is the one who deserves better service and advice from different market players.

Initially it may be exciting for retail investor to go directly to a MF and save entry load on his investment. But later when he needs advice on 'topping up' his investments or 'selling', if fund performance dips, there will be no after sales service available. MF is not a passive investment like Insurance which you buy for 20 years and put in the locker. Here you need active advice and it is inconceivable performing this role without active participation of a financial advisor. Sure, this policy will be investor friendly for the rich man in the big city but what about the small investor who is an employee of ONGC in Dibrugarh. Who will serve this investor

Is there room for improvement in standard of financial advice offered in India and the answer is definitely yes. There are other proposals like Regulation and Certification of Financial Advisors, which will help towards this cause. But the point to be noted is that encouraging direct investment by investors is not the solution rather it will further worsen the situation. Remember, retirees investing directly in technology fund IPOs in 2000 and burning their fingers.

If the regulator wishes to reduce the cost of purchase for MF investors, it can be done by introducing the variable entry load model where the pricing gets determined by market forces.

The writer is MD, Bajaj Capital Ltd