Why don’t direct plan investors get lower 1st-year expense?4 min read . Updated: 26 Jun 2014, 06:15 PM IST
There are a couple of pitfalls in the current scheme of things
Early last year, market regulator Securities and Exchange Board of India (Sebi) introduced the Investment Advisers Regulations, 2013. The main objective of this regulation was to differentiate between investment advisers (IA), whose remuneration would be the advisory fee that they collect from their clients, and the other set of wealth managers or distributors, whose remuneration comes solely from the manufacturers of the products that they recommend to their clients. While the regulations are well intended, they impose tremendous practical challenges for Sebi-registered IAs.
Each client has different needs and risk profile. The IA has to structure the advice accordingly. However, mutual funds (MFs), because of their relative simplicity and efficient tax structure, usually constitute a large portion of most clients’ investment portfolios.
Two challenges that IAs face with respect to MFs is the discrepancy in expenses between direct and regular plans, and the lack of information on investments.
Regular versus direct plans
For a Sebi-registered IA, advising a client to invest into direct schemes could be a clean and tangible way to demonstrate that there is no conflict of interest. For the client too, it’s good as she not only benefits from the adviser’s expertise in the form of better fund selection and monitoring, but also gains from lower expense in the fund. She need not worry about whose interest the adviser is serving, as the adviser is paid no brokerage or commission by the MF for bringing in assets. The adviser’s income will come only from the fee she collects from the client.
But then, it’s not so simple. There are a couple of pitfalls in the current scheme of things.
Logically, brokerages paid to distributors should be equal to the difference between the expense of the fund under regular scheme and under direct scheme. In reality, that doesn’t happen. Thus, while distributors get paid well for investments done through them (especially in the first year, when the brokerages can be close to the fund expense itself), direct plan investors are at the losing end. Is there cross-subsidization here? Why don’t direct plan investors get lower first-year expense?
There is another interesting loophole: MFs’ marketing and investor education initiatives. A reasonable portion of this pool of money finds its way into pockets of distributors, paid in some garb, to sell a particular fund.
Distributors exploit these two loopholes to the hilt. And I am not even touching upon the practice of set-offs or pass-backs, which are explicitly illegal and prohibited by the regulator.
This lack of parity between direct plans and regular plans needs to be corrected, and can be done quite simply. The brokerage paid to distributors should be the only difference between the expenses of the two types of schemes. If possible, there should be regulations regarding misuse of investor awareness fund, marketing budgets and the like. Up-fronting of brokerages should be discouraged. Trail commission should be the preferred form of brokerage payment, with the same amount being paid across time periods.
Lack of information
A distributor A’s Association of Mutual Funds in India (Amfi) registration number (ARN) code on a client B’s application tells the MF that A is the distributor for B. Any time A wants to know the status of B’s investments, she can ask the MF for the account statement. It’s that simple. But this simple facility is not available to a registered IA. At present, there is no provision to record the involvement of an IA. So, if she advices her client to invest into a set of direct plans, there is no way for her to get updates on those from the MF. How is the adviser to give portfolio updates to her client?
There is another critical piece of information that’s surprisingly difficult to get: the expense for direct plans. While I understand that the expense ratio for funds might change every month, but shouldn’t it be available in the monthly fact sheets, along with other historical data points? Or, as an “easy to see" tab on the home page? Just try searching for the direct expense of a particular MF on their website, and you will know the reason for my frustration.
Again, the solution is simple. There should be transparent disclosures of expense in direct schemes in the monthly fact sheet. It should also be displayed as prominently as the returns data. In fact, it would be a good idea to have these three figures—total fund expense, expense under direct plan and expense under regular plan—together, on every page of the monthly fact sheets.
MFs should share data with IAs just as they do with distributors. To this effect, there can be an ARN-like code (generated by the regulator) for IAs, which can be captured on the MF application form.
Investment advisory business is new in India, and has stumbling blocks that the industry or the regulators might not have anticipated. The need of the hour is clearly to remove these obstacles quickly.
Rakesh Goidani is co-founder and director, Entrust Family Office Investment Advisors.