The inclusiveness of India’s capital markets has often been a point of discussion. Given the high rates of savings in the country, it is extremely desirable that our markets become more attractive and accessible to the retail investors.

Mutual funds, easily one of the most suitable products for new and small investors, are probably best suited to spear-head this effort. A study conducted by McKinsey & Co., titled Indian Asset Management – Achieving Broad-Based Growth puts India’s total assets under management in mutual funds at 8% of GDP (as at 2007). Compare this with 33% in the UK and 39% in Brazil, and we realize that there is a massive potential for growth.

Further research also places the potential source for this growth – with the retail customer. McKinsey’s 2007 figures show that only about 4% Indian households invest in mutual funds. Another study conducted by IIMS Dataworks shows that only 9.5% of India has heard of mutual funds, and only 4.5% could describe the product correctly.

Clearly, investor awareness and more inclusive marketing by the fund houses can bring about massive growth in the retail investor segment that the markets need. We also believe that the introduction of online investment platforms will go a long way in making mutual funds accessible to areas where physical distribution networks can’t reach. Over and above these, however, only regulatory changes can make the market more transparent and equitable for the retail investors, bringing in a sense of security.

Our regulatory body, the Securities and Exchange Board of India (SEBI), as well as the Association of Mutual Funds in India (AMFI) are keen to bring about some fundamental change to address this. Two changes currently under consideration touch upon the charges that we pay every time we invest in a fund, and the role of advisers as service providers, and not just agents of the fund houses.

Briefly put, when investing in mutual funds, we pay some or all of the following charges, depending upon the nature of the scheme:

• Entry load: Levied at the time of investment. Up to 2.25% (in the case of equity funds) is deducted from your investments as entry load. Part of this is paid out to your adviser as commission.

• Exit load, or Contingency Deferred Sales Charge (CDSC) in some cases: These are charged by the fund house at the time of redemption, in case you redeem within a certain period. CDSC is a reducing sales charge that declines after an interval of time, becoming zero after a certain period.

• Annual expenses: These are charged by the fund on an ongoing basis, and are within the range of 1% to 2.5%. The expense fee is adjusted directly against the fund’s NAV. Part of this is also paid out to your adviser as trail commission.

The basic premise behind the regulations being considered by SEBI is that retail investors have no control today over the charges they pay to the fund houses (and through them to the distributors). There are also practices like churning of client portfolios to earn entry load, and rebating that SEBI wants to reduce, making the relationship between investors and advisers more transparent and service oriented.

In a regulation effected in January 2008, SEBI stated that investors investing directly with fund houses should be charged zero entry load.

Let’s look at the two new proposed changes and how they can make investing more rewarding.

variable pricing
The essence of this proposed regulation is to allow an investor and his adviser to mutually agree upon the charge that the investor pays as an entry load. SEBI believes that this will link the charges paid by investors to the services and quality of advice offered by the adviser.

SEBI is evaluating one of two ways to implement it: at the time of investing, the fund’s application form should have a separate section where the adviser/investor can indicate the commission to be paid to the adviser. This can be signed off jointly by the investor and the adviser. The other option is that the fund house does not charge any entry load on any investment – the investor directly issues a cheque to the adviser for the commission.

Feedback has been collected from the market participants on the preferred method to implement variable pricing. SEBI will announce its verdict once it has evaluated all the inputs.

multiple share classes
Already implemented in international markets, multiple share classes can be a way of implementing variable pricing.  AMFI has recently submitted a proposal to SEBI, recommending that it bring in a mechanism where investors could choose between different classes, with each class bearing different expenses or load structure.

If this is implemented, each fund can offer multiple “plans” with the primary difference between plans being that of the structure of charges. The benefit underlying this regulation is that investors can now choose the plan that meets their preferences and capability to pay fees.

To explain this further, let's look at the fee structures of the share classes in the US:

• Class A: Will have Entry Load and low Annual Expenses

• Class B: No Entry Load, but have Exit Load for a certain period of time and Annual Expenses

• Class C: Have low Entry Load and Exit Load, but higher Annual Expenses

Do note that while the fee structure of these plans is different across classes, all the classes of a fund invest in the same pool of securities and have the same investment objectives.

As this illustration shows, investors with different investment horizons and preference for paying fees at one shot or spread out over time, can choose the relevant class, or plan. Also, investors opting for Class A plans, have the option to negotiate the entry load with their adviser, bringing in the benefits if variable pricing as well.

Conclusion
We believe that these changes, once accepted and adopted in the market can bring in more transparency and a feeling of control for investors.

For example, if you are investing in a certain fund with a long term perspective, you’d probably prefer to go in for Class/Plan B. In this type you can avoid an entry load, as well as get the benefit of a reduced exit load, as long as you stay invested. Similarly, short-term investors may prefer to go in for Plan A, where they can avoid exit loads, as well as get a negotiated entry load based on the services provided by their distributor.

Investors, however, will also need to start viewing distributors as “service providers” and not mere product agents, and be willing to compensate them based on services provided. Clearer expectations set in terms of financial planning, transactional services, as well as ongoing portfolio tracking will certainly help in a more rewarding investment experience.