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New SEBI rules are going to ensure a paradigm shift in the mutual funds business

On the 18th of this month, two key changes were initiated in regulations governing mutual funds (MFs) in India. One, the Securities and Exchange Board of India (SEBI) abolished the practice of ‘entry load’ — the upfront sales commission — in MFs. And two, it was reported that the government would somewhat loosen the Know Your Customer (KYC) requirements for small investments made through the Systematic Investment Plan (SIP) route. Both of these are significant changes that will alter the fund investment landscape in the country.

According to a statement from the fund industry association’s (AMFI) chairman, the KYC requirements for SIP investments totalling less than Rs 50,000 a year need not require the possession of a PAN card by the investor. KYC requirement in MF investments (as in other types of transactions) arises from a 1999 law called Prevention of Money Laundering Bill. The basic idea behind this bill was that no one should be able to pass large sums of money through the financial system anonymously. Every entity was made responsible for positively knowing and verifying the identity of its customers.

As it was eventually (in 2007) applied to MF investments, this law effectively boiled down to the simple fact that you needed a PAN card to invest in funds. KYC has other requirements too, but the PAN card requirement was what tripped up most small investors.

Perched in a certain position, most of us probably think that having a PAN card is now universal in India. There are a huge number of people who earn around Rs 50,000 every year and could be saving Rs 500 or a little more every month. However, it simply isn’t worthwhile, or even practical, for them to get a PAN card made. These people who are unlikely to launder money should never be subjected to such provisions. The freeing of PAN requirement at the bottom of the pyramid will help democratise MF investments.

The other big change that SEBI has brought in is the abolishment of entry load on mutual fund investments. Entry load is an amount deducted by the fund that goes towards paying commission to the distributor who sells you the fund. Now, the distributor will be paid by the fund companies out of their own pockets. The investor will pay the distributor separately whatever amount the two mutually agree upon as a fair fee for the services and the advice rendered.

At first sight, this decision is a huge shock to the established business model of fund distribution. Based on what I’ve observed so far, the financial viability of many small and individual-owned fund distribution businesses will be severely affected by the new regulations.

There’s little doubt that, holistically speaking, SEBI’s decision is in the interest of investors. The fund distribution and financial advisor business has its share of sincere players, as well as manipulative ones. The crooked ones will flourish in other ways, but the straight ones will have to work hard to survive and create a new business model. Hopefully, the fund companies will help them do this.

For investors, the biggest positive impact will be that ‘churning’ could end. I hope that there won’t be much motive for anyone to induce investors to sell and buy just to generate commissions. But then, you never know what a fertile and profit-seeking human mind can invent.

Anyhow, it’s pretty certain that a whole new kind of fund distribution business will have to be invented.