Monday, October 13, 2014

My two cents on exit loads in Mutual Funds



Recently there was an article in the Business Standard - Exit Load is good for investors. A lot of conversation followed on twitter following this. My take on the subject:




Background
     
      A.  Briefly put, an exit load is a charge, given as a percentage that AMCs charge investors who redeem their units within a time frame mentioned. Recently, some AMCs have increased the periods for applicability of exit loads to 3 years and exit loads of up to 3% are being charged. This would mean that upto 3% can be deducted from your fund value if you redeem early.

B.  Recently SEBI has made it mandatory that AMCs plough back the exit load collected to the scheme, which would mean that when an investor exits the scheme, the exit load would be added to scheme assets, increasing the NAV. This per se would mean that existing investors are benefitted.

     C.  Twist in the tale: In view of the above, SEBI has allowed AMCs to increase the expense ratio by 20 bps (0.2%) !! This would mean that every investor in the scheme would, if the AMC decided, pay an extra charge of .2% to manage his funds!! It would seem that the amount charged to investors is far, far higher that what is collected from exit loads and in fact investors are on the whole losing out due to this.

Any discussion on exit loads would have to take all 3 points above into consideration.

Benefit of exit loads

Exit loads per se are beneficial to both the AMC and investors. It discourages trading in Mutual Funds. Transaction costs and impact costs of untimely sales have to be taken into account when there are redemptions by those who basically “trade” in funds. These costs end up eating into the NAV and reduce the gain of disciplined long term investors. Speculators time the markets at expense of long termers in absence of a load and therefore, in reality it is a good thing to have exit loads. The argument for exit loads is nicely put here.  Rajeev Thakkar writes: In India, people willingly lock in money in PPF, Life Insurance Policies, Tax Free Bonds etc. The REITs which will be introduced will also be close end structures. However when it comes to Equities, easy come easy go is almost seen as a birth right. Equities are among the long gestation asset classes and one needs a long term view to come here.
A lot of what is done by the Mutual Fund sector may be wrong. That needs to be criticized. However increasing EXIT loads on equity schemes is not one of those wrong measures. It is an honest attempt to inculcate the right behaviour through the means of incentives / penalties.

Also, from point B above, the exit load is ploughed back into the scheme and increases NAV for investors.

In the case of short term bond funds, an exit load would allow AMCs to invest in securities that match the load period.

In short, exit loads will inculcate more disciplined investing and better fund management by AMCs.

But what has happened…

From point C above we know that AMCs could have used this regulation of SEBI to increase the expense ratio by 20 bps. This can infact negate every benefit of having the exit load. The linking of the plough back of exit load amount to an increased expense for investors is what is incorrect. While higher expense ratios may be a separate topic, it is linked directly here to this rule of exit loads. It is only in this context that I look at exit loads negatively.  A higher expense ratio can severely impact your gains over the long run. Just see the benefits to ‘Direct’ investors who have benefitted from lower expense ratio. Investors can gain > 1% annually investing in lower cost Direct Plans. Extending this, a higher expense ratio due to this 20 bps makes a big difference. Adds up to a lot in the long run.

This amount is added to the profits of the AMC. We have seen AMCs paying large amounts of upfront commissions from their own pockets. The extra profits to AMC from exit loads can help AMCs bear higher upfront commissions and thus may encourage mis-selling.

Bottom line

I am all for disciplined investing. However, the time period of 3 years maybe too long to have exit loads. One major plus of investing in mutual funds is liquidity. Let us not hamper that. 
Secondly there should be a relook at the rule of allowing 20 bps to be added to the expense ratio. Some interesting tweets on the subject













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