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Equality Redux

Mutual funds have become an equal opportunity zone, courtesy SEBI

While those in the funds business are still grappling with the abolition of entry loads, market regulator, the Securities and Exchange Board of India (SEBI), has let loose yet another regulatory salvo at mutual funds. This time, it's a change that will ensure that smaller investors get treated at par with larger ones as far as exit loads are concerned. However, the implications of this change go much deeper - it could end up modifying investor behaviour in a crucial way.

Let's examine what it is exactly that SEBI has done and what it means. Preferential treatment and lower costs being offered to big customers is very common in business. I doubt whether there is any business in the world (mine included) that doesn't do it. The reason is very simple - bulk customers mean lower costs and higher margins. Moreover, large customers have a great power over businesses - if they take their business elsewhere, then that's a big chunk of profits gone in one fell swoop.

The fund business is no exception. Investors who invest in big chunks have always got a better deal. Funds have always had lower or zero entry and exit loads for investors who put in more than a certain amount. This amount was generally in the range of Rs 1-to-5 crore. After entry loads were abolished on August 1 this year, all asset management companies (AMCs) have revised (enhanced) their exit loads. However, they've generally stuck with zero loads for large investors. This differential treatment being meted out to large investors has now been banned by SEBI. Generally, exit load is higher when the money is pulled out soon after investment and drops or comes to zero for longer term investments.

There are two sets of justifications for exit loads. One, the fund company has spent a certain amount of money in capturing the customer and if he redeems too soon then the fund must get some recompense. And two, when an investor pulls out his investment it does some harm to other investors. Therefore, they must be recompensed by taking some of the redeemer's money and distributing it among remaining investors. Under the new rule, both concerns are addressed. SEBI has ruled that an exit load up to one per cent can be taken by the fund company as marketing expenses, but above that, the amount charged must be credited to the fund's net asset value (NAV), in effect, given to remaining investors.

It stands to reason that when a large amount is pulled out of a fund, then disproportionately more damage is done to other investors' interest. And large investors tend to do this more often. Big money is often more mobile and moves in and out chasing short-term returns. This is lethal for other investors because when a lot of money moves out in falling markets, then fund managers often need to sell the more liquid and the better quality shares. From this perspective, not charging entry loads from larger investor is specially damaging and SEBI's new fiat is spot-on in terms of protecting investors' interest.

Exit loads could well stop larger investors from opting for excessively short-term investments. Fund companies are worried that large investors could stop investing in equity through funds or may insist on separate low-cost institutional funds. They say that in many funds the low cost of servicing large investors actually subsidises smaller investors. While that may be true in some cases, there simply isn't any principled reason to oppose SEBI's ruling. 'Mutuality' is an important characteristic of mutual funds and equal charges from everyone is part of that.