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Opinion

At Yahoo: Loaded in Disfavour

At Yahoo, I write on entry loads and my distaste for them at Loaded in Disfavour.

(Reproduced)

“Bring back the entry load” seems to be the cry among distributors and advisors of mutual funds, as the new chairman of SEBI, U.K.Sinha, appoints committees to look into various aspects of the regulator’s functioning. Mr. Sinha was the head of UTI Mutual Fund earlier, where he had complained about the SEBI move to remove entry loads altogether in 2009 — the intermediary community now desires that he reverse the earlier SEBI decision.

First, what do I mean when I say “distributor” or “advisor” or “intermediary”? For the most part, they mean the person or company that sits between you and the actual mutual fund. They all perform the exact same function — filling out a few forms, collecting and filing certain documents. Some of them actually go the whole yard and provide advice. For this, they would earlier get a commission out of your investment — so if you put in 100,000, a 2.25% entry load would give them Rs. 2,250, and what was invested was the rest — Rs.97,750.

SEBI’s view was that you can’t be paid a big percentage for just filling out forms, and if some of these people were actually providing advice, they should charge the investor separately for it. Like you pay a doctor’s fee for advice and pay a pharmacist for the medicines, the idea was to separate the product from the advice. Now there was no lower bound on entry loads earlier, so mutual funds could have “self-regulated” themselves and made entry loads zero; they did try in spurts, with some funds making systematic-investing-plans (SIPs) load free for a while, and others keeping certain funds with high loads and others with low. But after 2005, the load situation set itself up at the upper bound of 2.25% from nearly all equity funds.

With banks and large companies setting up operations, the competition in the middleman space was intense — to the extent that they would tell investors that they would “share” the commissions received as part of the entry load to attract their money. This is like giving you part of your own money back, but in a field where the rest take that part anyhow, it seems like an advantage.

This became is a cartelized operation, even without the presence of an actual cartel – the industry behaves as one because they all believe it’s in their interest to do so. In such an event only regulatory influences can change behavior, and the removal of an entry load altogether was a great move. Yet, market players complain today that it was “too sudden”, they should have been given time, distributors lost big chunks of income, that funds lost a lot of investors.

But I pooh-pooh that argument. If distributors were paid 2.25% earlier, they are paid 0.5% to 1% today. Upfront. How? Since fund managers would take about 2% of the fund as an annual management fee (in part over the entire year), they were happy to part with some of it upfront to the distributor. What then, you might ask, if someone put in a large chunk and withdrew it immediately? Answer: Exit loads. Mutual funds started charging a sum if you withdrew too early, and in line with the commissions such loads are about 1%.

Additionally, distributors are paid 0.5% as a “trailing” load, every year. The total payment to a distributor over the year is now over 1% for most equity funds.  This money is paid by the fund management company as part of the fees they charge you (deducted from NAV every day).

Payments have moved from about 3% earlier, to about 1% now. So distributors do get paid, it’s just a little bit lesser. And that was on the cards. Worldwide, hedge funds charge 2% of investments as management fees, mutual funds charge about the same. This money is used for research, to set up trading infrastructure, to pay top-quality fund managers and so on. Why should a distributor — whose job is plainly to transport a filled form and a cheque from an investor to the fund house, get just as much? And then get paid every year for doing nothing?

For advice, they should charge the investor directly — and many entities have started to do that, from individuals to large companies. The concept of paying for advice separately will sink in, and like every disruptive change, it will hurt existing players first, who have no infrastructure for providing advice, and whose customers don’t understand the concept of paying separately. The immediate reaction is, and should be, to deny these customers service unless they pay — the smart customer will do his own research and buy from a mutual fund directly (most already provide online and direct access), and the rest will learn to pay. This will take time, but this is how a flawed business model needs to be fixed.

The distributors answer goes like this: “Listen, if you don’t give me commissions, I will go sell insurance, where they give me 5-20%, okay?” And they did. For about a year, the mis-selling in Insurance policies went up until the big SEBI-IRDA spat happened, and IRDA decided to clamp down on commission structures at ULIPs. Still, insurance policy commissions are very high and in comparison with a mutual fund, they have proved to be horrible investments. The mis-selling only lasts so long and as investors realize that their investments haven’t quite done spectacularly, they stop putting money in.

And finally, the aspect of losing investors in the last two years: In case no one has noticed, nearly all kinds of equity assets have lost customers in the last few years, including Portfolio Managers and Stock Brokers. Investors have pulled out of equity markets directly as well — figures on the NSE show us that we are below turnover levels of May 2007, four years ago. Turnover in single Stock futures, which were what retail investors loved, have gone down to a desperate 8,000 cr. on Tuesday (figures in 2007 were above 20,000 crores a day). With banks offering 10% returns on FDs, investors are flocking to them instead of equity funds, and with increasing interest rates, that migration will only go up.

And in this time — the last two years — equity funds have seen inflows return as markets went up (end-2010) and then some exits as markets fell. This is not abnormal. Markets fall because of selling pressure, and an exit from an equity mutual fund is just another form of selling pressure. The fact that mutual funds have lost some customer money to withdrawals has more to do with market dynamics than a drop in loads.

One method that advisors suggest, because investors don’t like to give multiple cheques, is to have those investors write down that “[N]% of my money should be paid as a commission”. But given the glorious track record of advisors in mis-selling, and the dubious record of investors in actually seeing what they sign, this would be equivalent to feeding investors to the vultures. And if getting an additional signature is fine, why not get it on a cheque instead?

The demand to reinstate entry loads for mutual funds is on shaky ground. Mr. Sinha has already stated that he won’t reverse the policy, and instead concentrate on what makes funds more investor friendly. Mutual funds have been phenomenal vehicles for investing — unlike the west, most of our top funds have consistently beaten our stock indices, delivered healthy returns, and kept costs very low. It would be useful to highlight that, instead of reinstating retrograde incentives for intermediaries who are getting increasingly irrelevant anyway.

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