We don’t need entry loads: Financial Express: 4th July 2011

Do we need intermediaries to run our financial lives? This is an important question because we tend to normally spurn them in, say, agriculture, where they add to transaction costs—in horticulture, they account for 65-70% of the final consumer price. But when it comes to finance, or in particular mutual funds, the broker has a different position. The broker, sub-broker or agent acts as the final point of contact between the investor and the mutual fund house. As there are costs to be shared here, the issue that arises is whether or not the investor should be mandatorily made to pay for their services.

In the past, until August 2009, the fund forced the investor to pay the commission as part of the euphemistically termed entry load of 2.25%. Sebi had quite rightly pointed out that investors were being misled into buying schemes where the agent got the highest commission. Often the agent would give us a part of it as an incentive, which made us feel good. But the truth was that when we were investing R100, a part actually never went into the market as investment.

The mutual fund industry’s view is that with the entry load concept being banned, less money has come in. First, this is hard to prove because post the ban on entry loads, the market itself has been wobbly, as seen by the fall in trading volumes on the NSE. Second, savings, including deposits, have taken a hit on account of high inflation. Finally, the earlier chairman of Sebi, CB Bhave, had argued that this was not the case and one should not look at net inflows but purchases, as people sell when they want to and not because of agents being there. Purchases had continued to increase.

But, for the sake of argument, let’s assume that the broker had actually brought in the money. By counter-intuitive logic, it can be argued that the fact that funds are not coming in only proves Sebi’s point that investors were being driven to invest by the brokers making promises that were probably not fulfilled. This is so because investors would continue to invest in mutual funds if they thought they took the right decisions when the broker was around. In fact, they would be willing to pay the broker for such guidance, which they are not willing to do today. In fact, today there is a plethora of ranking and guidance on the performance of mutual funds schemes and, in retrospect, it appears that agents were actually getting a commission for doing the administrative job of filling in forms and submitting to the fund. If this were so, then the logical corollary is that mutual funds should run their schemes on their own, just like banks do with getting deposits without agents.

A way out for mutual funds is to pay the agent separately, which will be an indirect way of loading the investor as it would go under operating expenses, which will impact the profit and NAV of the schemes. But this will add a modicum of transparency. Alternatively, mutual funds can have their own staff to do so, just like banks do for their credit products. This will also be loaded indirectly on the investor in terms of cost, but clearly the investors can choose those schemes that finally deliver better returns or have lower operating costs. Here, the onus is on the fund to perform.

This is where investor education is important. The Association of Mutual Funds in India should take the lead and run such programmes more aggressively across the country so that the benefit of these funds is extolled and investors educated about how they should view investments. The NSE does this even today, as do commodity exchanges like NCDEX where investor programmes are held to just inform the public about what stock or commodity trading is about and how to trade so that people are not just guided by brokers into doing what they want. This can be coupled with more effective direct online access to investors.

Given the expanse of the country and the level of financial literacy, there is information asymmetry between investors and suppliers of a product. Intermediation is a way out to bridge this gap and that is why we have banks, mutual funds and insurance companies. But when these intermediates bring in further lines of intermediaries, which can go to at least three levels, then the cost increases and the chance of misselling products is very high. Simplifying processes is a better way out for funds to garner money.

This is even more glaring when we look at insurance products where the insured are not aware that large percentages of the premium (going up to 20-30%) actually go as commissions in the first year, with a trailing commission that goes up to 5%. Quite clearly, the authorities need to check this and Sebi’s move is commendable and needs to be stretched to insurance where, invariably, the high paying commission products mobilise funds—the single premium products that serve the insured well but not the agent are rarely marketed.

At the ideological level, we need to actually see if intermediation is taking place efficiently. As we increase the tiers, different levels of efficiency and performance issues come up. Online trading addresses the issue adequately and the mutual funds should progressively work towards cutting down these layers. Clearly, the ones that can bridge this gap will be the most preferred, which is what competitive financial systems are all about.