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SEBI Changes Rules of the Game

At one stroke, SEBI has abolished entry load on mutual funds and started what is likely to be a complete transformation of the fund industry

After six months of anticipation, the Securities and Exchange Board of India's (SEBI) board meeting earlier today abolished entry load for investing in mutual funds. With this change, the business of selling funds will change fundamentally. The money that a fund distributor earns will now come almost completely from the so-called trail commission. This is the commission that the distributor receives from the fund house on a continuous basis while the money is invested.

The intention of the reform is clear -- to eliminate 'churning', or the practice of mis-advising investors to regularly sell existing investments and buy new ones. In the existing system, the distributor's profits come from the investor making a new investment. In the new system, his profits will come from keeping the investor invested, hopefully in a fund that will make good money.

There's no doubt that this is a crucial reform. With the markets looking up and fund investments shooting up sharply, SEBI has removed the biggest source of mis-selling that has been afflicting Indian mutual funds. Fund companies launch too many new funds while the distributor often make investors switch between funds just to earn their commission. Under the new system, the motive for doing either is gone.

What makes the reform particularly potent is that while the entry load (and the accompanying upfront commission) is eliminated, trail and other commissions also have to be revealed to the investors.

The new system has both pros and cons. As I wrote earlier, at this point, all the pros are for the investors and all the cons towards the distributor, or rather, the existing shape of the distribution business.

Here's what I wrote in April, when these changes were first proposed.

Evidently, the pros are all on the investors' side. Unfortunately, the cons are all on the side of the distributor. Many investors will underpay advisors while some may not pay them at all. Smaller distributors are often just individuals who are struggling to run their businesses alone. Now, convincing investors to give them a reasonable commission and chasing them for payments will be a whole new source of business stress.

The Law of Unintended Consequences

There's no doubt that this move will severely damage the businesses of many fund distributors. While the intention of SEBI's move is to reform the way funds are sold, it could end up by moving many smaller distributors out of this business altogether. In any business, the reduction of margins always impacts the smaller players first. This wouldn't be such a great thing to happen.

Moreover, it's also possible that there will be an attempt to maintain the status quo through some other route. Perhaps AMCs will create some sort of a 'non-commission' method of remunerating the larger distributors. Or perhaps the business will simply become unattractive and some AMCs and distributors will simply quit.

In any case, I'm sure that the law of Unintended Consequences will somehow come into play. What will actually happen will have some strange twist that we can't foresee today.

Also read:
Our special report on this variable load structure:
The Burden Of Commission