Much-maligned entry load was a cheaper option!
Cold calculations show that such is the draconian charges SEBI plans to introduce for fund investors, that even the horrible practice of entry load would have been a cheaper option for investors. The new charges also perversely penalise committed investors
Exactly three years ago the Securities and Exchange Board of India (SEBI) abolished entry load in order to reduce costs for the investors and induce investments. However, investors didn’t seem too keen and instead of inflows, we have seen a total net outflow of nearly Rs20,000 crore from equity funds till July 2012. Sometime later the regulator also brought in a transaction charge for investments above Rs10,000 to incentivise distributors. However, a majority of distributors opted out from the transaction charge. Now, in order to increase penetration into cities other than the top 15, SEBI has allowed the asset management companies (AMCs) to charge up to a maximum 30 basis points (bps) extra in the total expense ratio (TER) on the total corpus of the scheme.
Here is the strange fallout that bureaucrats in SEBI either overlooked or knew about. The proposed regulation will actually be more expensive than the highly controversial entry load that was abolished! This move may help increase penetration (we feel will it will only encourage unethical practices) but at whose cost? The additional TER will be charged to the entire corpus and investors would have to forego a part of their returns for the benefit of the AMCs. And SEBI not only is asking existing fund investors to subsidise the marketing efforts of fund companies but is hitting where it hurts most—long-term holding.
Let us analyse how the additional TER will affect the performance of a scheme which most analysts have kept quiet about, possibly because of vested interests.
We will look at three different scenarios, one is the present scenario where there is no entry load charged, the second is where an entry load of 2% is charged and the third is where there is an additional TER of 30 bps is charged. We have assumed the schemes deliver a return of 10% in all scenarios before deducting costs.
In the present scenario, ignoring the transaction fee (as it is not applicable to all distributors), if one invests say Rs1 lakh in an equity mutual fund scheme which charges the maximum TER of 2.50% and makes a return of 10% pre-expenses, the investor would have a corpus of Rs4.06 lakh after 20 years. This would mean that post expenses the investor earns a return of just 7.25% compounded annually. Not at all attractive for investors to give up the safety of bank deposits.
In the earlier regime, when entry load was applicable, the invested corpus would get reduced by 2% at the start. Therefore if an investor puts in Rs1 lakh, the amount invested would be Rs98,000. If this grows by 10% and if the expense ratio is 2.5%, the investor would be left with Rs3.97 lakhs after 20 years, working out to an annual compounded rate of 7.14% post-expenses. Note that the entry load made a dent on the return, but a small one.
Now if SEBI goes ahead and allows fund companies to charge the additional TER, the TER would go up to 2.80%. At that expense ratio, after 20 years, Rs1 lakh at 10% return before expenses would grow to Rs3.81 lakhs at a compounded rate of 6.92%. This is lower than 7.14% return that comes from 2.5% expense ratio and 2% entry load. Returns work out better when entry load is charged! In fact, with a 2.8% expense ratio, approximately just after six years, the total returns post-expenses, starts falling behind scenario 2 (2% entry load plus 2.5% expense ratio). The lesson: if you are a long-term investor, you will be penalised, even as SEBI and fund companies preach at every breath the benefits of long-term investing.
In order to negate the additional TER, SEBI has asked AMCs to create a separate plan for direct investors with a lower expense ratio. Seeing the practices of AMCs in the past, they may just reduce the TER by 30 bps which they would be charging to reach smaller cities.
Clearly, the great mutual fund experts, who are in the SEBI board and SEBI’s mutual advisory committee, have either not applied their mind or decided to be the mouthpiece of the fund industry to the detriment of investors’ interests. Some critics have said that SEBI has just managed to complicate the industry even further. Why is there a need to charge an additional TER to the entire corpus? In order to compensate the AMCs for reaching smaller towns and cities, SEBI could have just reverted back to the “entry load” for just these cities. It would have benefited the investors of these cities in the long run, as well. The AMCs too would have made their cut for reaching smaller investors. This would reduce costs for the AMCs as well as they would not have to put in resources for creating a separate plan for the direct mode. But the fact that these simple and commonsensical ideas are not in the proposal indicates mal-intent and not incompetence.
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