The abolishment of entry loads by the Securities and Exchange Board of India (SEBI) has come into effect from August 1. Entry loads were used to pay part of the commission that fund distributors used to get from funds. With this change, fund distributors will earn less. And since fund companies are likely to increase other forms of commission, they will earn less too. Many in the fund industry are convinced that this change will be bad for the business. This may not be true because I think lower cost and higher transparency will definitely attract more investors. Whatever be the impact on the profitability of fund-related businesses, there is no doubt that funds have now become an even better vehicle for your investments.
However, apart from entry loads, there are some accompanying changes in the rules that investors must understand. The most important of this is the higher incidence of exit load in equity funds. Earlier, exit loads in funds were generally around one per cent for amounts withdrawn within one year and zero afterwards. Above a certain amount, which used to range from Rs 2 to 5 crore, the loads were lower or negligible. In fact, the proper term for this kind of exit load structure is 'Contingent Deferred Sales Charge' (CDSC). As the name indicates, it is a sort of a deferred entry load which is charged only if you exit the fund too quickly.
To understand exit loads, investors should understand what they are for. A part of exit load is kept by the fund company to pay for marketing and related expenses. The rest goes into the fund itself, that is, the money is added to the assets belonging to the fund's investors. According to SEBI's new regulations, up to one per cent of the exit load can be used by the fund company for its own sales expenses. Load charged over and above that will have to be added to the assets of the fund itself. The logic for handing over this money to the remaining investors is that the exit of any investor harms the remaining investments and this is compensation for it.
After the abolition of entry load, fund companies have generally enhanced exit loads. The time period during which it has to be paid has been increased to two or three years and the percentages have also been increased to 2 per cent, especially for periods under a year. Generally, investors can count on zero exit loads only for investment periods longer than three years. Initially, funds had continued with their old habit of not charging exit loads from larger investors. Loads were mostly not charged for investments over Rs 1 or 2 crore. However, last week SEBI banned this practice. It issued a circular saying that investors must not be discriminated against on a quantitative basis.
Exit loads are supposed to deter investors from pulling out their money quickly and certainly they should be a dampener against the rapid fire investment and redemption that some investors did. This is a welcome move. While exit loads act as a barrier against liquidity, there is no point in investing in a mutual fund if you are going to try and time the markets. With a two or three per cent load, investors would be seriously deterred against pulling out their funds within a year or so and that's a good thing.