Entry load: How SEBI’s decision benefits investors

The Securities and Exchange of India’s (SEBI) decision to remove entry load on all mutual funds from August 1, 2009, is commendable. Mutual fund distributors would then have to directly charge their customers fees for investment advice. But how would such direct commission structure benefit the investors?

This article discusses the issues related to the existing commission structure. It then applies behavioural psychology to show how the proposed structure is different. It also explains why the direct commission structure is likely to improve the quality of professional advice.
Free or fee?

The mutual fund industry primarily relies on distributors to sell the investment products. This leads to two structural issues.

One, distributors recommend products based on the individual merits. But a “good” individual product may not be optimal within an investor’s existing portfolio. The reason is that each mutual fund sold as a separate product could lead to portfolio concentration risk.

A classic example is that of an investor who has 10 different diversified funds, bought one at a time.

Since all diversified funds invest within the same universe of stocks, a portfolio of such funds will lead to concentration risk. Such a portfolio is simply a case of fund diversification, not portfolio diversification.

This problem arises because all distributors are not trained as professional advisors — those that typically risk-profile a client and recommend custom-tailored portfolios.

Two, distributors do not directly charge their customers for recommending a fund. Investors, therefore, believe that distributors offer free service.

Unknown to most investors is the fact that the distributors are paid by the asset management firm for recommending a customer. And this money typically comes from the entry load that mutual funds charge the investors.

Investors often end up paying the distributor a fee for a product that they may not fit with their investment objective.

SEBI has sought to bring about transparency in the commission structure by removing the entry load.
How would that help investors?
Choice architecture

Behavioural economists argue that decisions can be influenced by the way choices are presented. We believe that SEBI’s decision to remove entry load can influence the way investors view professional advice. Here is why.

Currently, the lack of transparency in the commission structure means that investors use distributors as a default choice.

From August, the explicit fee structure will force investors to make a conscious choice to go to a distributor.

But would investors’ behaviour change after they learn that distributors earn a fee even in the existing structure? The answer lies in what behavioural economists call as framing bias.

Suppose SEBI were to continue with the current commission structure.

This means an entry load will be deducted from the amount invested and a fee will be paid to the distributor. The investor will not feel the pain, as the fee is not an explicit cost. An investor can, however, avoid the entry load if she invests directly in a fund. The fee saved will be viewed as cash gained.

In the proposed structure, an investor would have to pay advisor fees explicitly if she routes the investment through the distributor.

The fee paid will, hence, be viewed as cash lost.

Research has shown that investors take great pain to avoid losses. That is, they are more likely to give up gains (save fees) than accept losses (pay fees). And that means distributors will no longer be a default choice.
Conclusion

Would investors at all pay for professional advice? We believe that SEBI’s choice architecture could “nudge” investors to value professional advice.

Not all investors are discerning enough to make direct investments. The ones that want advice would have to choose between distributors and professional advisors. This would increase competition in the advisory business and improve the quality of investment advice offered. And that would be beneficial to the investors.