The
Securities and Exchange Board of India’s (Sebi) circular dated 18 March
2016—that mandated additional disclosures about how much money your
mutual fund distributor makes on your investment in absolute terms and
how much salary your fund managers (and other top mutual fund
officials)
earn—kicked up quite a storm.
Fund houses will now need to disclose how much commission your
distributor has earned on your investment—on a half-yearly basis—in your
half-yearly common account statement (CAS), in absolute terms. The
statement will also show the expense ratio of direct and regular plans
of your MF scheme. The fund houses’ websites will provide details of how
much their money managers and chief executive officers earn. Scheme
Information Documents of every MF scheme will also mention how much—if
at all—they have invested in that scheme. There are a few other
requirements, but they are not as important, so we will leave them aside
for now.
I want to turn the attention to two of Sebi’s most crucial
requirements. The need to disclose distributor’s commission in absolute
terms, and the mention of expense ratio of direct and regular plans in
your CAS.
What the numbers show
Let’s begin with disclosing distributor’s commission. Why does Sebi
want you—the investor—to know how much your agent is earning?
Presumably, to ensure that you are sold the right product, that you get
comfort from the fact that your distributor has not earned anything out
of the ordinary, like an expensive foreign holiday, to sell you the MF
scheme. That’s fine. Nothing wrong here.
But how will investors react if they see distributors’ earnings, in
absolute terms? There could be three possibilities. First, no reaction.
Second, some investors might be tempted to pull out if they feel
distributors are earning way too much on their investments and go
direct. Third, they may ask for a rebate. Let’s see how and why.
Take a look at the table. We assumed a mid-cap fund and that you invest
Rs.50,000
every month in it, through a systematic investment plan, between March
2006 and March 2016. Over the 10-year period, you would have invested a
total of
Rs.60 lakh. As on 1 March 2016, your portfolio value would be
Rs.1.46
crore. As per rough calculations, your latest half-yearly CAS (as on
March 2016) would have shown your distributor having earned about
Rs.77,800 as commission for the period between September 2015 and March 2016.
These are rough numbers as we have assumed a trail fee of 1% per
annum and have also calculated the trail fee based on the 6-monthly
average assets under management of the portfolio.
Actual numbers will vary depending on the formula each fund house
uses. Also, how MFs account for gifts and money spent on distributors,
apart from commissions, remains to be seen. This is a simple
illustration of one way of how trail commissions could look in your CAS.
My point is: will it not bother you knowing that your distributor has earned
Rs.77,000
as commission on your investment? That too, for just the previous six
months? In this example you have been investing for the past 10 years.
Take a closer look. Between September 2010 and March 2011, due to
market volatility, the scheme’s net asset value dropped and so did the
value of your investments, from
Rs.42 lakh to
Rs.39 lakh. Now see your distributor’s commission. It went up marginally, from
Rs.18,936 to
Rs.21,888.
This is due to short-term volatility and also because trail fees in
this example are calculated using the past six-month average corpus. In a
continuous market fall, the trail fee will go down. Still, it could
bother many investors.
A susceptible investor is likely to be alarmed if she sees that her
corpus has gone down, but the distributor is still earning a commission,
and which has gone up. Step forward to 2016 and we now know that this
investment grew to become
Rs.1.54 crore
(as on 23 March) but it’s a real possibility for the same investor to
have been upset in 2010-11 when the economy was in a bad patch.
It’s also human psychology. While a percentage figure of 1% doesn’t
bother you, an absolute number just seems larger and might make you
reconsider your investments. The moment you put a figure, and if that
figure runs into thousands—which it will if, ironically, you have a good
distributor and one who convinces you to stay invested for the long
run—it sets the cat among pigeons.
Finding worth
Some believe that distributors should not get trail fees in the long
run because if advice is what is required to convince investors to stick
around, then Sebi-registered investment advisers (RIA) should be the
ones giving the advice, and not the distributors. We’ll come to that in a
short while.
Meanwhile, upon looking at the absolute commission figures, some
large and mass affluent investors might use this as an opportunity to
demand a cut from their distributor’s commission. It is possible that
distributors, especially those from Beyond Top 15 cities where financial
literacy is poor, might feel obliged to give a cut from their
commission to investors in volatile markets when customers see a drop in
valuations. Corpus can fall not just due to bad advice, but also market
volatility. Although commission passback is banned, it still happens
privately. And it could potentially get worse.
After telling you how much money your distributor has been making on
your investments, Sebi now wants you to turn your attention to another
detail that your CAS will now disclose; your scheme’s expense ratio of
the regular plan (the plan in which you have invested in) as well as the
direct plan (the cheaper cost plan that is devoid of distributor fees).
Suffice to say that if you have already been riled up at the fact that
your distributor has been making money even as your fund may have shown a
short-term loss, say, during volatile times, you may get tempted to go
direct and save the commission. This may not be Sebi’s intention but
investors switching to direct plan is a possibility we cannot ignore.
That’s the danger. Direct plans are not for everyone. They are only
meant for those investors who have the knowledge and the skill to pick
and choose MF schemes on their own. And for those who have the time to
do the added work of tracking funds regularly. Unknowing investors who
think they can manage portfolios on their own without a distributor’s
help, face the danger of investing in a wrong scheme and suffering far
greater damage than just the difference in the expense ratios of the two
plans.
Why, then, not go to a financial planner or a Sebi-registered
investment adviser, pay her fees for advice on investments and financial
planning and then invest through the direct plan? Also, if distributors
are merely vendors, then why should they advice and earn fees (trail
fees)?
Sebi’s vision appears to be to have two classes of sellers; one is a
distributor who is a vendor and should, therefore, disclose all
commissions that she earns from the fund house. The other person is the
adviser who charges fees to you—the investor—and then routes your
investments through direct plans. In doing so, Sebi has nudged
distributors to either become registered investment advisers (RIA) or
remain as distributors but disclose fees.
RIAs are supposed to disclose fees too, but since Sebi has now
allowed them the direct plan route (starting 2016), they are now in a
better position to justify their fees.
There are two problems with this approach. RIAs—who can demonstrate
value—will be able to pull in customers who are willing to pay. But this
breed of customers is still small in India. The remaining investors—who
don’t want to pay an adviser and therefore choose to stick to a
distributor who doesn’t charge a fee—will now get to decide if their
distributors are paid adequately or not.
Secondly, disclosures are good. But the scheme’s total expense ratio
(TER) figure is what we should be looking at. If Sebi feels that the TER
is high, it should simply reduce it. Or, if it feels that the trail
fee—after a point in time—should be capped, then it should say so. Such
measures are not only enforceable, they also send out a message that if
Sebi feels that higher costs prevent MF penetration, then a reduction in
costs will now lead to higher penetration.
Further, disclosing a tad too much also looks like a soft nudge by
Sebi to distributors to become financial advisers. The regulator seems
to be thrusting a change into a distributor’s business model, based on
which some distributors will stop earning trail fees, overnight. A
standalone distributor cannot become an RIA presently unless she decides
to let go of her trail commission overnight. Unless she forms a company
and keeps her distribution business (that earns trail commission on
legacy clients) in a separately identifiable department. That bit is
allowed by Sebi’s RIA guidelines.
That brings me to my earlier question: should distributors—or
vendors, as some people call them—earn trail fees? If trail fees is
earned for advice provided, then why should distributors earn trail
fees? And if so, why fear the disclosure of trail fees in the CAS?
Since trail fees are paid to the distributor for as long as the
investor stays invested, it doesn’t naturally mean that the distributor
is giving investment advice here. It need not be a fee paid for advice.
Even to convince the investor to stay invested for a long period of time
itself is a task, which—in cases of those distributors with a high
persistency ratio—is hard work.
And if the distributor has gone out and acquired a customer, there
should be no harm in paying a trail fee, especially since it’s a fee
that rewards the distributor for investor’s patience. Sure, there are
investors who readily stick around and distributors earn trail fee
without doing anything. But such investors are in a minority; else MF
penetration numbers would have been much higher.
The last point
Disclosures are a must. But how much disclosure is good? Ultimately,
what is the aim of a disclosure? To encourage MF investments? To reduce
misselling? More importantly, are investors armed to make sense out of a
particular disclosure or does it have a danger of being misinterpreted?
Also, if Sebi is keen to change its own rules (for example,
distributors can earn trail commission till the investor stays
invested), then it should allow time for existing distributors to shift
to the new fee-based model. By influencing investors’ behaviour without
first educating them to correctly interpret the added information they
are about to get, Sebi has not sent out the right signal. The intent is
good, but the method is not.