The new distribution regime and the mutual fund industry

Having been in the mutual fund industry for nearly 14 years I have seen it evolve from being an industry that was virtually nothing in the year 1995 when I joined SBI Mutual Fund as a research analyst to a significant and growing part of the long term saving of the Indian individual and corporate sector. At that time it was an industry that had hardly any private players and was largely dominated by UTI in its earlier version. At that time, like in case of shares there were physical certificates and most of the funds that were launched were in the close ended form. There were a few other public sector bank promoted mutual funds and a couple of private ones. Mutual fund penetration was very low and it was largely a push product on the distribution side.
Over a period of the last 15 years now we have nearly 32 players in the industry, with 5-10 more looking to come in. However given the change in the regulatory regime for mutual funds, mainly related to amortization of expenses and elimination of entry loads it is now a different business than what it was a few years back.
Till around 3 years back when funds were raised by mutual funds in both the open ended and close ended form they could charge off around 6% of expenses to the investors as fund raising expenses. This was typically used to pay distributor commissions of 3-5% and other initial expenses like forms, advertising, presentations etc. These expenses were pretty steep as it cut out 6% upfront from the investible funds and as such returns would be earned on the remaining 94%. This entry load was done away by the regulator around 3 years back. However since the distributor community had got used to high commissions the level of commissions paid remained at elevated levels of 3-3.5% upfront for raising funds in NFO’s and 2.75-3.25% for ongoing schemes. These commissions were paid out of the entry load of 2.25% and an additional amount of around 0.5-1.25% was paid out to investors by the AMC’s from their own pockets. With this kind of upfront payouts it became necessary for AMC’s to retain the clients and as such exit loads were slowly bought in and increased to promote long term investing. Besides the upfront payouts typically distributors would get around 0.5-1% as trail commissions. The net income for mutual fund companies thus typically is in the range of 0.75-1% in case of equity products on an annual basis.
In case of close ended funds the amortization of expenses were allowed till last year and given the fact that these were locked in funds distributor commissions were stronger for close ended products. As such close ended products are unlikely to come back in the near future.
Recently there has been an announcement by the regulator with regards for the elimination of entry loads from all funds. This is likely to bring about a significant change in the way distribution is carried out in the country. Since the upfront income is going to reduce significantly a long term advisory model is likely to gain shape. During the bull market of 2003-2007 a lot of investors lost out on the real up move mainly due to the fact that some specific distributors became infamous for churning of investor portfolios in order to earn more and more upfront commissions. This led to a phenomenon where a lot of investors missed out a large part of the bull up move. The reasons are simple, since the markets were moving up so sharply every three to four months investors were making a return of 10%, and just where the new fund got fully deployed and became ready to give the real upside to investors some of the short term focused distributors churned them into another NFO. In this manner a number of investors never made any big money in the big up move but ended up actually losing money on the downside as on the downside there was no churning as no one would churn with a loss.
Today as I interact with a lot of distributors and advisors they are very disheartened with this move and believe that their business will be unviable. However I believe that the mutual fund industry is still very small in size and has to grow much bigger from where it is today. Total equity assets of Rs 150000 crores is nothing compared to the total market capitalization. The number of investors in equity mutual funds is still around 2 crores out of a total population of 115 crores and growing at the rate of the total number of existing investors today, every year. All equity mutual funds as a proportion of total market capitalization is just around 3%. I believe that this will go upto a level of 10% over the next five years. Also given the fact that my view is that we are at the start of WAVE 3 of the big bull market in India and that I see the markets at around 35000 level of the Sensex over the next four years, equity mutual fund assets should be in the region of atleast Rs 600000 crores at that time. Thus just the total trail income (if we assume it at 1%) will grow from Rs 1500 crores to Rs 6000 crores over a five year time frame. This combined with at the chance of earning atleast around 1.5% I upfront for new sales in the form of 0.5%-1% upfront commission from mutual funds and an advisory fee of 0.5% from clients should generate an income of around Rs 1000 crores per annum if we assume only 10% of total corpus as new sales and churning. Thus the overall fee income from this business a few years from now will be atleast Rs 7000 crores. Thus it is not going to be a bad business to be in. Advisors providing value added and proper advice can actually increase their market share significantly. I think that the number of distributors might reduce but for those who remain it will still be a lucrative business.
So what about the mutual fund industry, I believe the moves taken in the interest of investors over the last few years will lead to a consolidation in the industry with the larger players with older assets (raised during the amortization era) becoming stronger. Mutual funds will also have to focus on spending more on their fund management capabilities and move away from being just strong marketing organizations. Performance will become much more important as distributors move from a transaction based to an advisory annuity model. Smaller sized mutual funds will have to really revisit their growth strategies and concentrate more on niche segments as in the generic products they will find it very difficult to compete with the larger more established players. NFO’s will go down in numbers and better performing existing products will get a greater response from the investors and advisors. New and smaller sized fund houses will see a slow and steady growth backed by performance and the days of big bank growth through large sized NFO’s might be a thing of the past.
However competitively there is one more thing to mention, which is that this makes the mutual fund equity schemes less attractive for distributors to push vis a vis ULIP’s of insurance companies (which effectively get sold like mutual fund schemes). Given the commission structure of ULIP’s they might become preferred products to push. However what the investors have to realize is that finally the large commission payouts of ULIP’s is going out of their own funds and in the long run it will impact their returns negatively. Commissions earned by insurance distributors should also be made public as is going to be for mutual fund distributors.
Overall I still believe that distribution of mutual funds and other equity related products will still remain attractive given the growth prospects of the Indian economy and the stock markets.

However the rules of the game have changed in favor of a long term advisory based model instead of a transaction based one.

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