It is now getting close to a year since the Securities and Exchange Board of India (SEBI) abolished entry load on mutual funds. During this period, much has been said and written about how an old business model will have to change and how people will transition to a new one. But looking back at what has happened so far, one negative impact of the SEBI's directive is very clear. It is now utterly uneconomic for anyone in the mutual fund industry to serve retail investors. Unless some miracle happens, from now on, mutual fund investment is an activity that will be entirely limited to wealthy individuals.
Let's see why this is so. Consider a small investor, who would probably invest something in the range of Rs 10,000. If he's figured things out a bit better, he would also start an SIP (systematic investment plan), probably about Rs 2,000 a month for a period of one year to begin with. As things stand now, the advisor who has done the job of convincing this investor to invest, may get remunerated with about Rs 75 to begin with. Later, after a year, he starts getting a continuous commission of about Rs 25 a month, likely paid quarterly. This is the trail commission for the total accumulated investment of Rs 34,000, as well as an estimated gain of 10 per cent a year. Eventually, the customer might invest more and the money will accumulate. However, that requires a certain period of customer support, hand-holding and contact. But, is there money in the system to pay for these services? If you multiply the above numbers by five or ten, then the answer possibly is yes. However, a rich investor (although the word rich is taboo, so we now use the awkward euphemism high-networth individual), who puts in Rs 1 lakh to begin with and then Rs 10 or 20,000 a month, would not find any problem in being serviced well.
Is there no way that a customer can be serviced at lower investment levels? There is, but only if that customer already has some other financial connection with the service provider and the cost of customer contact and acquisition can be amortised over a larger business. In practice, this means the service provider is necessarily a bank. It's only your bank that could find it economic to sell you a mutual fund for a small amount. Unfortunately, that's not a great solution for the customer. Of all the entities that distribute mutual funds, banks have the worst track record of systematic mis-selling. In any case, banks are far more interested in guiding all possible customers towards products with the highest possible commissions.
In effect, that's the situation now. Simple business economics, combined with the way mutual fund regulations have evolved, has ensured that the small investor is unlikely to become a mutual fund customer. Equity funds remain by far the best way to invest in equity in a gradual, transparent and flexible way and the effective shutting out of the small investor from equity funds is not a great outcome. Mind you, this is not an argument for creating upfront incentives. No matter what today's problems are, it must not be forgotten that the root of all mis-selling in all financial products is distorted incentives. If a financial product incentivises the seller for creating a transaction, then that's all he will do. Upfront commissions were the root cause of mis-selling in mutual funds. If you want to see a truly horrifying example of upfront commissions laying waste to investor's savings, you just have to look at India's insurance industry. Therefore, higher upfront commissions (or any upfront commissions at all) are certainly not a solution. From the investor's point of view, the best outcome is a long-period of good returns and the only solution is a compensation system that rewards the intermediary for that.
This article was originally published on July 16, 2010.
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