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The Good Load

Mutual fund exit loads are back

Mutual fund exit loads are back. They are back to a certain extent in actual funds, but far more than that they are back as a topic of discussions within the industry. The discussions are mostly about how exit loads are a desirable feature in many types of mutual funds but how they won't actually get implemented because investors dislike them. Actually, I'll try and show that investors should prefer funds with exit loads because they ensure that the precipitate actions of some other investor in a fund are much less likely to harm them.

First, let's see what exit load is. Exit load is a deduction from you investment that is made when you redeem your money. Actually, the correct technical term for this kind of charge is 'Contingent Deferred Sales Load' (CDSC). It is a sort of a deferred entry load whose levying is contingent upon an investor exiting a 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 logic is that the fund company has incurred a certain amount of cost in initiating an investment.

However, this cost will be broken even and then some money made only after a period of time. If the investor quits too early, then the fund company must recover the cost some other how. Beyond the fund's 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.

Over the last year, a few changes have taken place (or are in the process of taking place) that have made it imperative for fund companies to start charging load. In equity, the abolition of entry load has meant that investors must stay for a reasonably long term for the business to make sense. Many fund houses have already affected these loads. However, the real struggle is with exit loads in short-term debt funds. SEBI is in the process of making changes to these funds (which are used mostly by corporates) that make it a problem if investors exit too early. Do note that too early in these funds means a matter of days. When a large investment flows out of such a fund, it causes problems in running the fund as well as possibly slightly lower returns for other investors. The ideal solution is to impose an exit load for investments less than a fortnight or so. However, no one in the fund industry seems to think it will work. The investors in these funds are corporate CFOs who are much more hands-on than individual equity investors.

These professional investors may simply not accept an exit load and the result will be that they will only choose those funds that are exit-load free. I don't know whether corporate investors will ever abandon their straight line thinking but the logic of exit loads is very simple. If the exit load will apply to periods that are much shorter than your planned investment, then it actually makes your money safer.