IMPACT OF ENTRY LOAD BAN IN MUTUAL FUNDS

Background

The Indian Mutual Fund (MF) industry has witnessed one of its major transformations from
August 1, as the ban on entry load investments in all MF schemes imposed by the market
regulator Securities and Exchange Board of India (SEBI) comes into effect. SEBI has
instructed that mutual funds cannot levy any entry charges for investments but allowed
distributors to claim a fee for their advice from investors. It also directed them to disclose
commissions earned to clients.

Concept of Entry Load

“ Entry Load ” is an upfront charge levied by fund houses when you invest in various MF
schemes. This load used to vary from 0% to 2.5%.

This load was charged (supposedly) to compensate the MF houses for marketing and
distribution costs. The charging of entry load resulted in less of investor’s money being
invested in an MF scheme.

For example : If you invest Rs. 5,000 every month in a MF scheme; and if there is an entry
load 2%, Rs. 100 would be deducted upfront from your investment. That is, instead of the full
Rs.5,000, only Rs. 4,900 is actually invested in the fund.

IMPACT OF ENTRY LOAD BAN

SEBI’s move to ban entry fees for investments into mutual funds will lead to a jump in long-
term inflows as distributors adjust their business models to generate more volume and trail
fees (recurring fee paid to the distributor).

Positive result of this move

According to analysts, “This is one of the most significant changes that the mutual funds
industry has seen in recent times. It is a positive move for the benefit of the investor
community, for the benefit of regulation and for the transparency of the mutual funds
industry.”
It would reap a host of benefits to the investors such as :

 Higher returns for the same investment

 Lesser advice to churn your portfolio

 Improvement in quality of service due to fee-based advisory services

 Lesser New Fund Offers (NFOs)
  Change in the attitude of investors

IMPACT ON DISTRIBUTORS

The ban on entry loads – the 2.25-2.5 per cent fee mutual funds charge investors on schemes,
which is used by money managers to pay distribution commissions – is seen by insiders as a
paradigm-shift reform for the Indian market.

This move by SEBI will have major impact on distributors and the Independent Financial
Advisors (IFAs), as their margins are likely to take a major blow. But several fund houses
have already started to promise an upfront commission of 2% to the distributors. Sabapathy
Iyer, CEO of JR Laddha Financial, a distribution house, in Mumbai said, “How long are the
fund houses going to pay the upfront commission? In the long run, only those who provide
better service to the investor and have maintained a cordial relationship with their investors
will survive.”

The ban is expected to have a big impact on the way distributors take care of their clients.
“What has been happening until now is that once a distributor sold a fund he forgot about the
investor. Now he will have to continue to be in touch with the investor, providing real
services, so that the investor feels obliged to pay the distributor.”

“Clearly there will be a reduction in business and activity will slow down. The ban will
change the intermediation that existed earlier, because of the revenue pool that fund managers
and distributors work on and which they share between themselves will be reduced from
August 1 onwards.”

"It will discourage unnecessary NFOs (new fund offers) because what was happening is a
distributor who was earning 2.5 percent commission was interested in churning people from
one scheme to the other just to make sure he makes his commission,"

As per data compiled by the Association of Mutual Funds in India (AMFI), ‘More than half
of the 1.2 trillion rupees equity assets of the funds industry was less than two years old at the
end of March, 2009’ as a result of frequent churning. This is set to change now as distributors,
who get an upfront fee from about 2.5 percent entry load that equity funds charge will now
have no interest in making investors switch funds.

Instead, they stand to gain more in the form of trail fees or the money they get from fund
houses on continuous basis, if investors kept the money invested longer.

“Distributors will evolve an advisory fee model and will also get remuneration from fund
houses for distributing products either in terms of upfront or increased trail,”

While the changes will hurt distributors revenues in the short-term and limit fund firms ability
to gather assets in new funds by paying large upfront commissions out of entry fee, it make
investing cheaper and more transparent for investors. A distributor "would be more interested
to keep his trail alive," Abizer Diwanji, head of financial services at consultant KPMG said.

The ban is also likely to have a negative impact on India’s $137bn (€96.4bn, £86.2bn) mutual
fund market, because distributors will have less of an incentive to promote new products
offered by the mutual funds.
“In the short term there will be disruption to business, as distributors will try to find other
products that reward them better,”

Fund managers also fear that, in the short term, they may face growing competition from
insurance and pension funds, since distributors are likely to market more products similar to
mutual funds that have not been hit by the entry load ban.
However, over the medium to long term, fund houses and distributors are expected to revamp
their business models and will look for new pay-out structures, according to Sukumar Rajah,
chief information officer at Franklin Templeton India.

Mr Kumar of IDFC believes that the short-term fall in product launches from August 1
onwards could be compensated for by a strong market performance and more active mutual
fund investors. “Most investors believe the rule change is a good move; it will make investors
a bit more proactive

IMPACT ON EMPLOYMENT OPPORTUNITY

The asset management industry does not invest directly in building a large sales force to
market and sell its funds to investors. Third party distributors are very important.

Mutual Fund companies will continue to focus on selling products through its distribution
partners as they find it difficult to envisage funds taking their products directly to clients. The
awareness of funds is not very high, and the average retail client is not very comfortable
deciding from the vast array of choices.

Currently there are only 75,000 AMFI certified agents in the country which is very low for a
country India’s size. That entails a lot of education and investment; the low margins of the
industry are not allowing it to make that investment.

This scenario gives a wide range of employment opportunity as Asset Management

Companies (AMCs) would now look to employ people directly for marketing and selling their
Mutual Funds to the investors.

On the other hand, it is also likely that Distributors would now employ less sales force to
market and sell funds as there is no margin for them. There are various distributors in the
market who employed such people, who might have to bear the brunt of this entry load waiver.
AMCs might plan to deploy its own task force but they would mostly be highly-skilled as
against Distributors who employed lower-skilled force with the capability to just “market” and
“sell”. However, AMCs would not be able to match up with the competency and penetration
level of the Distributors.
CONCLUSION

The fixed entry load structure followed earlier, had an embedded conflict of interest for
distributors. As distributors made a fixed sum on mutual funds notwithstanding their
performance, they had an incentive to push MF schemes, even if the investor did not require it.
This led to constant churning across schemes and hindered long-term asset creation.
Therefore, it is appropriate that SEBI is putting an end to this practice. In the new scheme of
things, the investor will pay a fee to distributors and has the option to negotiate it based on the
quality of the service provided.

In a nutshell, the new regulation will lead to long-term asset creation. However, there is no
clarity on whether investors or AMCs will be paying commission to distributors. A majority of
retail investors do not have the tools to find appropriate information about financial products.
Therefore, it seems that they are not on an equal footing with distributors. The latest move
might complicate matters, as it expects the investor to negotiate with distributors on their own.
Investors should be really cautious, especially if the distributor seems overeager to sell ULIP
products.

To conclude, Paul Samuelson, winner of the Nobel Prize in Economics rightly said :

“A small man – anyone with a portfolio of, say, under $100,000 – is unlikely to do as well
investing his own money as he can do in a no-load fund.”

***********************