In March 2016, Ahmedabad-based Ashish Shah listed his distribution firm of financial products, Wealth First, on the small- and medium-enterprise (SME) platform of the National Stock Exchange (NSE). But this was not the first financial services firm to get listed. According to data aggregator, Prime Database, a total of 51 financial services firms have listed on the two main stock exchanges as well as their SME platforms.
Since Shah does not charge his customers any fee, he had to look for alternative avenues to raise money to expand his business. He says he will use the money he raised through the capital market to open a new office in Bengaluru.
Since the Securities and Exchange Board of India (Sebi), abolished entry loads in mutual funds (MFs) in 2009, distributors have been forced to change their business models to keep income streams flowing. Sebi’s continued intensity of reforms has made distributors charge customers directly, and justify their fees. While some have begun to charge fees, some continue to earn from fund commissions (in the form of trail fees). A few, like Shah, have looked for alternative means like an initial public offering to fund growth. Some distributors have taken to high-commission products like portfolio management services (PMS).
Walking the PMS path
Although a PMS strategy fetches a distributor an upfront commission as high as 3-4%, as opposed to 0.60-0.90% in an equity MF scheme, it would be unfair to say that the high commissions are the only reason why distributors have warmed up to PMS. “PMS and MF schemes appeal to different investors. In India, traditionally there have been more retail investors in direct equities than in MFs. So there is always a demand for direct equities. And since investors may not have the time or the expertise to hunt for companies, that is where a PMS fits in," says Aashish P. Somaiyaa, managing director and chief executive officer, Motilal Oswal Asset Management Co. Ltd. According to corporate database provider, Capitaline, market capitalisation of individual investors in direct equities is about 8.76 trillion (as on 26 May). Retail investors hold about 2.20 trillion in equity-oriented MFs, as per Prime Database. “It is inconceivable to think that all direct equity investors will sell their equities and switch to MFs. So, PMS appeals to a section of direct equity investors," adds Somaiyaa.
Motilal Oswal Asset Management’s own Value Strategy PMS returned 14% and 12% (on a compounded annualised basis) over the past 10-year and 5-year periods, respectively, outperforming many MF schemes. Its ‘Next Trillion Dollar Opportunity’ PMS returned 28% and 32% over the past 5-year and 3-year periods, respectively, again outperforming many mid-cap MF schemes. There are a few more examples of success, and failures too.
PMS strategies are of mostly three types; discretionary, non-discretionary and advisory. Discretionary and non-discretionary PMSs have a model portfolio consisting of stocks. Fund managers buy and sell stocks, on your behalf, based on the model portfolio and a strategy. In a discretionary PMS, the fund manager buys and sells stocks on her own, without asking for your permission. In a non-discretionary PMS, the fund manager has to ask your permission before buying or selling a stock. Unlike in an MF where money is pooled into an account, and the fund manager collectively buys stocks and you get your fund’s value by way of a net asset value (NAV), a PMS manager has model portfolios, each with a list of companies bound by a common theme. Each investor has a separate demat account where her stocks are kept, separately. Money, too, goes in and out of an investor’s separate bank account. So, a PMS investor holds a bagful of stocks in her demat account.
Many fund houses have a separate PMS division, and as per Sebi guidelines, these have independent fund managers and research divisions.
In advisory PMS, a fund manager provides just advice; you execute the trade.
“For MF schemes, a fund house has to file offer documents with Sebi, get its approval before launching, and there are limits on how much it can invest in individual companies and sectors. A PMS does not have a scheme to manage or get approval from Sebi. Fund houses who want to operate in a similar space as equity funds but who do not wish to operate at a large scale can use the PMS route. Minimum investment in a PMS is 25 lakh. So, it caters to a different set of investors," says Rajeev Thakkar, chief investment officer, PPFAS Asset Management Co. Ltd.
While Sebi governs PMS fund managers and has laid down guidelines on how the funds can be managed, cost structure related reforms that were initiated for the MF industry have bypassed PMS products. That is one reason why distributors like Vinod Jain, principal adviser, Jain Investment Planner Pvt. Ltd, a Mumbai-based distribution firm, started selling PMS in 2010.
Between 2001, when he started his firm, till 2010, Jain had built a formidable MF systematic investment plan (SIP) machine. When MF entry loads were abolished in 2009, the equation changed for Jain. “The day the entry load was removed, our average monthly SIP amount was 2,500 per SIP. On that, we made an upfront income of about 600 in the first year. And any new recruit takes five years to build a 10-lakh a month SIP. With the entry load, it used to take 3-4 years to break-even with a new adviser. After the entry load abolishment, we found it tough to hire new recruits and make it profitable," says Jain.
Apart from avoiding SIP applications of less than 25,000 per family, Jain turned his focus towards high net worth individuals (HNIs). Here is where PMS came in and he started selling Sundaram Asset Management Co. Ltd’s PMS. In 2015, Jain Investments also filed for, and got, a PMS licence. Jain now wants to invest his clients’ money directly in equities. He has spent the past six years grooming a team that he can use once he rolls out his own in-house PMS products this year.
Having an in-house PMS increases a distributor’s revenue if she can demonstrate management capabilities. Typically, a PMS provider offers more than one fee structure. For instance, one option could be a flat, say, 2%, annual charge based on the investor’s assets under management (AUM). Another option could be a 1% annual fee based on AUM and 10% on profits. But there is a watermark concept here. For instance, if the NAV goes up in the first year from, say, 100 to 200, the profit is 100 on which the PMS charges a profit sharing fee. Say in the second year, the value goes down to 150. A loss means zero profit sharing. But in the third year, if the NAV goes up from 150 to 220, then the profit will only be 20 (220 less 200); the high mark that the PMS had touched in the first year.
Apart from the management fee of 1%-2.5%, a PMS strategy also comes with additional charges like custody fees, audit fees, exchange fees and so on, to the tune of about 0.2%-0.3%. The profit sharing and distribution commission cost comes over and above, depending on the PMS fund manager and strategy.
Wealth Advisors (India) Pvt. Ltd, a Chennai-based boutique wealth management firm started by V. Mahadevan and Pramod Kumar, runs its own PMSs. One product invests in direct equities, another specialises in an asset allocation strategy that invests across various products, including direct equities and MFs. “In fact, our experience in non-discretionary will be relevant as we transition to advisory services," says Kumar.
While Kumar and Jain’s PMS forays come with the backing of years of experience in tracking direct equities, many distributors gravitated to selling PMS after Sebi abolished entry loads in 2009, significantly due to higher commission. “Because of high charges and cap on upfront fees in MFs, many distributors have misused this to offer similar products through a PMS structure," says a chief executive officer of a fund house who did not wish to be named.
Shift to advisory
Meanwhile, in 2013, Sebi introduced the Registered Investment Advisers (RIA) guidelines. These guidelines forced a sizeable section of distributors to get registered with Sebi. The take-off was slow; up till December 2015, there were only about 350 RIAs.
To attract more advisers, effective January 2016, Sebi allowed fund houses to give feeds of direct plans to RIAs. With this, RIAs can now charge fees to their clients and channelise investor money into direct plans of MFs and demonstrate the cost saving. A direct plan is meant for an investor wants to invest in an MF directly, without a distributor’s help. So, it does not come embedded with distributor fees. RIAs can now access their investors’ direct plan investments’ details. Sebi had asked fund houses to offer direct plans in all their schemes in 2013. Now that RIAs can offer direct plans, it changes things. At present, number of RIAs has gone up to 431.
Ravi Kumar T.V. and his wife Kshitija’s distribution firm, Gaining Ground Investment Services in Bengaluru, could get added to this list by the end of this year. Having started to distribute MFs in 2004, the couple found themselves at the crossroads when MF entry loads were removed. Working mostly out of their homes till then and with a modest set of customers, they found it difficult to acquire business. So, in May 2011, they opened an office, got registered as a private limited company “to corporatise the business", and by 2012 started offering financial planning services. Today, Gaining Ground spends money on sophisticated tools to just do a detailed risk profiling of all its financial planning clients. Kumar and Kshitija say that in about two months, they will apply for the RIA licence. “If the (financial planning and distribution) profession has to emerge and become mature, it has to be regularised to give direction. If (the) regulator wants us to comply, we want to embrace it. It is most rewarding for people like us, as we get a licence for what we already practice without the RIA title," says Kshitija.
To charge or not to charge?
That is the question many distributors have been asking. Bengaluru-based Srikanth Bhagavat, who runs Hexagon Capital Advisors Pvt. Ltd, used to charge a flat fee of 5,000 every year to all his clients before entry loads were abolished. Once that happened, he changed his fee structure and started charging a certain percentage of a client’s AUM every year. He also started charging an upfront fee at the time of signing up a new client, for making a comprehensive financial plan. “It was not easy but an opportunity to become less dependent on commissions if we took this sudden reduced revenue in the right spirit. There was a lot of resistance," says Bhagavat. About 5% of his clients walked away, but the rest, he says, remained and started paying “as they found value in our advice". In May 2014, Hexagon Capital Advisors became a Sebi-registered RIA.
Many found it tougher. “There is pain in paying. If any adviser says that it was easy to charge, take that as partial truth," says Kumar. In 2012, Kumar’s firm slowly started charging fee. Some clients agreed to pay, many others took time to be convinced. “In India, people are not used to paying their advisers as it is always free. They do not mind paying their auditors for tax filing… people like to hire and pay fees if something is compulsory and legally binding. Investing and planning is optional," he says.
Then, there are those who are happy to continue as distributors. Chennai-based distributor A.K. Narayan refuses to charge his customers, although he says his revenues dropped after the ban. “You need a lot of courage and experience to switch to an advisory model. Investors do not understand the implication of not paying; many are not ready to pay fees," he says. Narayan, who started his distribution firm in 2004, spends a lot of time conducting financial literacy campaigns every month, which, he says, 50-60 people attend. Does he sell any particular products there? “No, of course not." But here is where many of his clients have come from; about 4-5 people from most of these sessions become his clients.
Sebi chief U.K. Sinha has said on many occasions that expense ratio (and the commission that fund houses pay from therein) must come down. Will commission-only distributors survive the change? More importantly, is there space for this group? “Distributors do have a role to play. A pure distributor model will go away at some time and only the advisory model will remain; I am sure of that. But the distributor model is important as it services investors who invest 1,000-3,000 or so every month through SIPs," says Narayan, adding that a distributor model of earning fees is fixed as the MF pays him commission. “If I charge fees and the markets go down in some years, some customers might not pay up; what do I do then?" he asks.
Narayan, perhaps, represents a large but slowly fading breed of distributors who are still playing the wait-and-watch game of how distribution and advisory regulations play out in India.
On its part, Sebi shows no sign of slowing down. With the deadline of 1 October to publish distributor commissions on account statements coming nearer, distributors will get yet another, perhaps their biggest, nudge so far to move towards advisory and recommend direct plans. In the face of recent protests against this move though, how Sebi reacts remains to be seen. Either way, a distributor who shows value will remain in business. Everyone else will perish.
Read the first two parts of the series here: http://bit.ly/212cZyO and http://bit.ly/22LafaA