Now that mutual funds have been disallowed upfront commissions, there are conversations about market regulator Securities and Exchange Board of India (Sebi) considering the removal of upfronts for other managed products like portfolio management schemes (PMS) and alternate investment funds (AIFs). These products are sometimes more complex in strategy and come with a much higher minimum investment base ( 25 lakh and 1 crore, respectively) making them more suitable for defined risks that high net-worth (HNI) and ultra HNI investors seek. 

Despite the assumption of better awareness and HNIs’ enhanced risk-taking ability, there is a need to standardise disclosures, make them more transparent and nudge out grey practices like upfront payouts. An industry person  familiar with the development, who did not want to be named, said, “Complaints have come in to the regulator about investors losing money and the idea is that regulatory arbitrage that now exists between products like mutual funds, where everything is transparent and captured within regulatory limits, and other managed funds needs to be considered." 

Can MF industry-like transparency and tightening of rules around commission payouts help in ensuring that HNIs and ultra HNIs are served nothing but the best? 

For distributors, upfront commissions mean revenue booked today versus a year or three years later. This is how it works: a managed fund like a PMS most likely carries an exit load for 3 years, while AIFs are closed-end funds with a tenure of 3-7 years. Hence, it is easy to extrapolate that the assets brought in will remain for this defined period. These products come with a recurring annual fee of say 1-2.5% which gets charged to investors and a portion is paid to distributors as commission. Where commissions are paid upfront, the entire amount is aggregated for the defined tenure at the time of the sale—thus, the distributor books a revenue of 3-4.5% immediately. 

For an investor, this upfront has no direct impact on the cost of investment or the return they earn. However, a high upfront payout can wrongly incentivise a distributor to make a sale or convince an investor to put money in a product which otherwise may not have a strong investment rationale. 

Munish Randev, a family office advisor and mentor, said, “Initially when entry loads were abolished, there was a system of claw back along with upfronted commissions and then came closed-end funds where upfronting of commissions was possible since there was no chance of exit. Once the direct code was approved for MFs, many institutions, especially foreign banks, were quick to approve domestic PMS structures, which were till then not approved. It happened in a bid to garner higher commissions from PMS upfronts and trail. Here too, as one client was often served by more than one distributor for the same PMS, fees began to get further negotiated. Now, it’s about AIFs; these are closed-end and upfronts can happen with the set-up fee, trail can come from management and operational expenses."

This kind of needless churn in products—be it within a product type or between other managed funds—is perhaps what Sebi is considering putting a stop to. While one may not find fault with the product itself and as in the case of any managed fund segment, there will be good and bad performers, the idea that high upfront fees determines what gets sold is hard to digest. 

If upfronts are disallowed for PMS and AIFs, distributors will have no choice but to realign business models. A bigger impact could be on newly-formed asset managers offering PMS and AIFs and newly-set-up distribution where the profitability curve could flatten out and break-even can take more time. 

A senior industry executive, who did not want to be named, said, “It’s a matter of time that upfronts will become zero, the shift will be to direct with advisory fee. Many fund managers who have quit their jobs to start their own PMS or managed fund could find it difficult to grow assets too fast and newly established players (wealth managers) will have a tough time." 

While such a move could shrink immediate revenue, the cost of hiring an experienced advisor with existing clients is unlikely to stop increasing, potentially shrinking profit margins. “As entry barriers go up, it’s likely that the industry will see more consolidation," said the executive quoted above. 

For the investor, it’s good news if it comes through; reliance on trail commissions will potentially equalise the lure of one product over another in terms of earnings for distributors and ensure that the pitch is more about what’s relevant to clients. 

George Mitra, managing director and CEO, Avendus Wealth Management, said, “While there is no economic impact of such a change, if it happens (removal of upfront), the genuineness of advice will be less in question. Advisory will be more professionalised, will create better alignment with investors in selecting investment options and perhaps lead to better innovation in products like AIFs." 

There are also discussions that the minimum investment threshold for PMS could get enhanced above 25 lakh along with standardisation in performance disclosures. “Other than closing the gap on regulatory arbitrage between mutual funds and other managed funds, there is also a thought that PMS regulation has not been altered for nearly two decades whereas the industry has evolved," said the first person quoted above on the matter. 

Recently, we saw Sebi doing an overhaul of mutual fund expenses to make them more relevant to the growing size of individual schemes. 

Historically, it’s apparent in distributor behaviour that search for profitability leads to needless product innovation that can circumvent regulatory bans. A long-only listed equity AIF, for example, which aggregates “best ideas" across existing mutual fund schemes, is hardly a productive launch. But it gets sold. Removing upfronts will help, but simultaneously, the regulator must be willing to penalise mis-sellers and perhaps review investment strategy even for AIFs, where so far only the approval for the structure is considered rather than the inherent strategy. 

Prateek Pant, co-founder and head - products and solutions, Sanctum Wealth Management, said, “If there are reasons to believe there is mis-selling then that should be addressed. However, these are bespoke products which allow HNIs to take specific risks and in bringing in uniformity and standardisation one hopes that the innovativeness of strategies where they exist don’t get discouraged."

The more aligned an existing business model is with investors’ objective, the easier it will be to adapt to any regulatory changes.

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