1st June 2012

Over the last couple of days, we asked a number of advisors about whether they thought variable entry loads are a good solution to the travails of the MF industry and its distribution partners. When we asked Pranav the same question, his response was that the industry is missing the basic point in this debate. It all boils down to who is the target investor who we are addressing. If the whole debate on variable entry loads is about finding a better fee collection mechanism from the existing set of few lakh investors who are experienced mutual fund investors, then variable loads is a good way forward. But, if we are talking about spreading MFs beyond the few lakh existing investors into several crore potential first time investors, we are completely barking up the wrong tree with any discussions on fee collection alternatives, says Pranav. Reproduced below is the gist of his views on why he believes the industry is missing the whole point.

This talk about bringing in variable entry load to correct the mistake of abolishing entry load frankly amazes me. The fact is that a mistake has been made in abolishing entry loads. Telling distributors to go and collect fees from clients - in one form or another - whether two cheque or single cheque, is not going to address the core issue.

Core issue is penetration, not value of advice

The core issue is simple - mutual funds have a very long way to go to become a familiar financial product in the Indian household. And until such time, you will have to focus your energies on how to reach more and more Indian households and not to find more and more ways of asking fees from the existing MF investors. The core issue is not about demonstrating who is a better advisor to the small set of investors who are currently MF investors and collecting a fee from them on the strength of your advice - the core issue is bringing in many more investors into this industry.

Consider the facts

There are 120 crore people in India. Of this, there are only 8 crore PAN holders. The number of actual people who have filed income tax returns is even lower - its only 3.5 crore individuals. The balance 4.5 crore acquired PAN cards for various reasons - from ID proof for mobile phone to a compulsory requirement in the company they work. Peons in large companies have been asked to acquire PAN cards because it is a compulsory requirement - they are never likely to submit an income tax return since they are earning less than 2 lacs thrashhold limit.

Now, out of these 3.5 crore income tax assesses, there are only 40 lakh individuals whose income is greater than Rs. 5 lakh per annum. Only 40 lakh from a population of 120 crores. And it is these 40 lakh individuals who are today the core investors for the MF industry as well as stock market.

This entire discussion on charging fees for advice - whether through a second cheque or through a variable load or any other mechanism - is aimed at a section of this 40 lakh savers who have invested in mutual funds.

What is our priority : to refine a fee collection model or bring in new investors?

We are missing the whole point here in the debate on variable entry loads. What is the number one priority for the MF industry? What is the developmental role of SEBI? To find a way in which fees can be collected from a fraction of the savers of the country - through a two cheque versus single cheque mechanism? Or to find a way to reach out to many more lakhs and crores of savers, who yet do not know what mutual funds are and how to benefit from investing in mutual funds?

How will a first time investor evaluate the value of advice and decide an appropriate fee?

If the biggest priority is to reach out to a larger population rather than swimming in the same small pond, how can anyone realistically say that a fee based mechanism is the best remuneration for the individual who reaches out to these investors? Who can realistically say that it is reasonable for an MF distributor to explain what mutual funds are to a first time investor and then expect that this first time investor will willingly decide how much to pay as advisory fee even before his investment has been actually made and even before he has seen the experience of investing in mutual funds? In which world are we living?

Bringing in a first time investor is a huge task - why will somebody do this without adequate compensation?

Bringing in a first time investor into the industry is a huge challenge in itself. You have to first convince him why mutual funds are a good alternative for this investor's long term wealth creation needs. If he gets reasonably convinced, you have to ensure he has got a PAN card or arrange for one if he hasn't. Then you have to ensure that he is KYC compliant or process his KYC if that has not yet happened. Then you have to do the in-person verification. You are supposed to take all these efforts in the hope that when the first transaction is actually executed, this investor will pay you a fee - even before he has seen any benefits of this entire experience.

In-built pricing is the only way forward

I frankly think we are just beating around the bush rather than tackling the core problem. If SEBI and the MF industry desire retail penetration, there is no other alternative but for the AMC to compensate the intermediary for his efforts. This compensation has to come from a built in pricing of the product - whether through an entry load or through higher annual expenses.

The fundamental flaw in a fee based model is that it presumes a certain level of awareness on the part of the investor. Once that basic awareness is there, the investor is able to differentiate the advice of one advisor versus another and is able to decide who is adding more value and who therefore he wants to hire as an advisor and how much he wants to pay for this better quality advice. Fee based model - whether two cheque or variable entry load is fine if SEBI thinks that mutual funds should limit their horizons to the 40 lakh tax payers with income above 5 lakh.

Let us all admit our mistakes, correct them and move forward

But, if the vision is beyond this, any discussion on whether one fee mechanism is better than the other misses the whole point. You have no choice but to humbly admit that banning entry load was a mistake and restore entry loads as a built in pricing mechanism. We all have to learn from our mistakes - the MF industry and distributors too need to learn from their mistakes of the last bull market. Checks and balances should be brought in to ensure that excesses are not repeated. The right discussion should be how to prevent abuse of entry load, how to prevent churn, how to penalise churners. Once you have that framework in place, bring back entry load and genuinely incentivise the distributor who is going to go out in this difficult market to convince a first time investor to invest his savings into this industry.