The asset management industry has seen substantial growth in the past few years. It is a healthy trend that more Indians are participating in the Indian growth story. But even after all of this, the number of Indians investing in mutual funds is not more than 3-4% of the population. What the industry needs is a quantum jump. Structurally, it needs to get its act together to move to the next phase. One of the issues that need to be addressed is the way money is distributed and the fees the whole chain charges. Any business needs to have suitable compensation, but this also needs to be fair to the end customer. Only then can a business grow to maturity.
At present, the moot point is who the asset management companies (AMCs) consider their clients—the intermediaries or the end investors? If one looks at the way AMC business is structured, you wouldn’t be wrong to surmise that intermediaries are the clients. The regulators are aware of the issue and there have been at least three committees in the recent past to look at the issue of distribution. The Securities and Exchange Board of India (Sebi) has come out with guidelines for the way mutual funds are sold, advised, and distributed. But in my view, the suggested guidelines will not help resolve the issues. Most intermediaries will become distributors and true advice will get a short shrift. It’s time to remove the arbitrary distinction between distribution and advice. All intermediaries should have a fiduciary responsibility to their clients, the investor.
Sebi has done a commendable job in helping proper benchmarking of performance of active managers in the recent past. The information on returns and use of benchmarks for comparison has made the real ‘performance’ of active managers a little more transparent. Now that we know how any fund manager is performing, rationalisation of fees charged should be the next step.
Taking the thought process forward, a change in the way fee is charged by an AMC will help resolve issues of: a) distribution, by making the end investors the centre of the business model and resolve the conflict of interest for the intermediaries, and b) help make the cost structure fair, transparent and driven towards longer-term investing. An active fund manager asks for money to be managed on the basis of the fact that she will perform better than the benchmark. So it should be fair that she earns only when she beats the benchmark—either in terms of higher returns or lower risks. With the rationalisation of fund classification and benchmarking, these calculations are now easier. If a fund manager’s sole criteria for investors to give her money is an ability to give higher than benchmark returns, she should earn only when she actually does it. Today, the AMCs charge anywhere between 0 and 10 basis points, to manage pure passive funds like exchange traded funds (ETFs) and various other products. So, taking that as a base cost to manage a basic fund, and adding another 15-20 basis points as the cost of generating alpha, they should be allowed to charge a total of 25 basis points on a daily basis instead of the nearly 300 that they do. One basis point is one-hundredth of a percentage point. If they beat the market, then they should be allowed to charge fees up to the present cap. The suggestion here is not to reduce any fees; just change the way fees are charged so that it applies only when one delivers.
This is operationally possible. Assume a client invests on day 1. She will be charged 25 basis points on a daily basis. As and when she redeems, based on the outperformance to the benchmark, additional fees will be deducted before the funds are redeemed. The redemption could be on day 10, 100 or 1,000 or 10,000. The end investor too will know at the time of redemption how much the asset management fee has been and how much the intermediary fee was. If the fund has beaten the benchmark, then it should deduct the fees it would have levied under the existing regime. The investor will know the ‘outperformance’ fee and the fees paid to intermediary as one amount, rather than it being lost in a maze of smoke and mirrors.
One grouse of the intermediary community is that the investor is averse to paying fees for advice and therefore the fees have to be clandestinely taken. But an enumerated approach will help change the investors’ mindset. The intermediary will have to move into a space where fees from the client become more predictable and fair. This will also help longer term investing and reduced churning. In turn, this will help resolve the issue of the way mutual funds are distributed as the intermediary will truly have to work in the interest of the investor. The intermediary, and the fund manager, will only earn when the investor gets returns as promised.
Sanjiv Shah is former chief executive officer of Goldman Sachs AMC India.