There are also what are known as no-load funds which do not use a sales force or a distributor to sell their products.
By Sunil Parameswaran
Mutual funds levy a sales charge known as a load, for subscriptions and/or redemptions through an agent. The agent could be a stock broker or an insurance broker, or another intermediary in the financial markets. There are also what are known as no-load funds which do not use a sales force or a distributor to sell their products. However, while no-load funds sound passive, they may nevertheless advertise aggressively.
It was thought many years ago that load funds would cease to exist. For, why would a rational investor pay a sales charge, when he can transact directly with the fund. However, load funds continue to be popular. There are two reasons for it. First, most investors value the counsel and advice of an intermediary. Second, while many years ago the load was always imposed at the time of investment, subsequently exit loads and level loads were introduced.
With an entry load the entire amount invested will not be deployed, for a portion will be deducted as a load.
In contrast, if the load is imposed on exit, the entire amount invested will be deployed at the outset. In the case of a level load there is no load on entry or on exit, but every year an amount equal to the load is paid from the assets of the fund to the sales agents. This option appeals to fee based planners. As per behavioral finance theorists, fee based planners do not mind paying an annual fee, but dislike deductions like loads, whether on entry or exit.
It was felt in the US that a form of continuing compensation is required for sales agents to motivate them to service accounts, even after the investors have made an investment. In India, many of us would be familiar with a family insurance agent. He would have sold a policy to your father on getting his first job. He would have sold a second policy when your parents got married, and possibly a third when you were born. Thus, the family investment counsellor will make periodic interventions during the lifecycle of a family.
Stay invested for long
The mutual fund industry thus sought a levy to provide this kind of recurring compensation to their sales agents. In response, the SEC approved a 12b-1 fee, which allows the funds to deduct an amount from the assets of the plan every year. The fee also includes a component for advertising and marketing expenses incurred by the fund.
In India, entry loads have been dispensed with, but many funds continue to levy exit loads. A more investor friendly exit load is what is called a Contingent Deferred Sales Charge (CDSC). This is an exit load, where the percentage of the load declines the longer the investor stays invested.
For instance, a CDSC of 2,1,0 would mean that the load will be 2% if the investor exits before a year, and 1% if he stays longer than a year but exits before two years. Investors who stay with the fund for longer than two years do not pay a load. This kind of a load provides an incentive to stay invested for a longer period. And for a given growth rate for the NAV of the fund, the reducing exit load translates to a higher rate of return for an investor who stays with the fund for a longer period.
The writer is CEO, Tarheel Consultancy Services