SEBI's move to scrap entry loads on mutual funds may have been well intentioned, but it tripped badly in failing to assess the ground realities and the consequences of its actions

Five months after the Securities and Exchange Board of India (SEBI) scrapped entry loads on mutual fund (MF) schemes, the industry continues to be on the decline with further ill-conceived band-aid like trading through stock exchanges failing to attract investors. In the five months after the SEBI move, Rs7,200 crore of funds have moved out of equity schemes and flown, almost entirely, to Unit Linked Insurance Plans (ULIPs).

SEBI's move may have been well intentioned, but it tripped badly in failing to assess the ground realities and the consequences of its actions. It failed to visualise that sharply higher commissions paid by the insurance industry will suck money out of MFs. It also failed to ensure the availability of inexpensive alternative distribution channels. Consequently, investors continue to pay commissions, but only to other intermediaries such as banks or others in the exchange traded system. The question is, when will the regulator admit its mistake and initiate corrective action?

If SEBI had attempted to seek feedback before bringing in the regulation, it would have highlighted the impact of a hasty scrapping of entry loads on the fund industry and cautioned it against blundering ahead. A report by McKinsey & Co, the leading global consultancy firm, had enumerated some key issues even in August 2009, when the SEBI order came into effect. Even then, the fund industry was in turmoil and assets under management (AUM), which had been growing at 50% on a year-on-year basis, had declined by a sharp 17%.

McKinsey had pointed out that bank and national distributors who have control over the "customer's wallet" would be in a position to charge. That is exactly what is happening today. Banks were blamed for extorting huge paybacks from Asset Management Companies (AMCs), they have smoothly switched to debiting customer accounts for advisory fees.

McKinsey had also said that AMCs would have to continue compensating distributors (mainly banks) from their reduced fees. They may also increase exit loads for customers across holding periods—but this would be restricted to 100 bps. Here is what else McKinsey had predicted for the industry.

• Higher exit loads and transparent commissions would reduce the propensity to churn investments.
• Portfolio management services and alternate products will grow faster. AMCs and distributors will push higher margin products, especially debt products. This has indeed played out as predicted.
• The industry will undergo consolidation since smaller AMCs would find it difficult to manage the stress on their finances. Entry barriers will increase and it may even be difficult for new schemes to find distribution partners. However, the fact that SEBI has over 12 to 14 pending applications seems to suggest that the financial sector is not giving up on the mutual fund industry as yet.
• Most pertinently, the report had pointed out that it is IFAs (independent financial advisors) who help in geographic penetration of financial products. With IFAs, especially the smaller ones losing the incentive to sell mutual funds, the geographic penetration of the industry was bound to slow down. McKinsey's data shows that beyond the top eight cities, IFAs are the dominant distribution channel accounting for just under 50% of the market.