Last week, I wrote about how the abolition of entry loads and how investors should be willing to pay a fair remuneration for the mutual fund agents' services. As I'd pointed out, the abolition of entry loads had changed the underlying model for all parts of the fund business. In some ways, this transitioning is the trickiest for fund companies and most of them are trying to come to grips with it. For fund companies, the change the abolition of entry loads just the final one in a series of regulatory changes over the last two years that have completely changed the economics of the business.
Till about X years ago, the business was very straightforward. Reduced to its simplest terms, running a successful AMC was about bringing in new fund offers which were largely financed by investors. Fund companies would invent new ideas for funds which were just variations on the same old theme but were designed to sound like an innovation. SEBI would approve these NFOs, presumably because they sounded different. Then, fund companies would launch huge ad and marketing campaigns to promote the NFOs. However, the key to whole exercise were the commissions that were paid to the distributors and the lubricant which made the system work smoothly were the six per cent issue expenses that could be deducted from the investors' funds. This six per cent deduction was invisible to investors because it was not deducted from NAV at one go but amortised over three years.
Now, a series of changes that have culminated in the abolition of entry load has removed this six per cent from the equation. Now, investors get fund units for every paisa that they pay. All the expenses and commissions have to be paid by the AMC. Based on what I hear from fund companies, this has now become a business that requires some serious investment and patience. A reasonably large NFO which would reach a few hundred crore rupees is likely to cost anything from 0.5 to 1.5 per cent. This money has to be invested by the AMC and then recouped from the fund over one to two years. Even then, the actual profitability would depend on how much assets stay with the fund and how they grow with the market.
Of course, this is not the business model that the regulations were designed to create. The ideal would be to move away from the NFO-based model that has ruled so far. The regulator has made NFOs tougher in a non-financial sense also. AMCs now have to prove that the NFOs that they are proposing are genuinely new funds and not just minor variations on existing ones.
The answer is not in having a low-profitability NFO model replace the earlier one but in moving away from an NFO-based approach. Ideally, the investment cycle should start by an investor wanting to buy a fund because it fits his needs, and not by hearing of a hot new NFO. This shift will require a long time, but the changed rules of the game have ensured that this shift has begun.
This article was originally published on May 26, 2010.
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