Is Sebi nudging investors in mutual funds to go direct?

The websites of the fund houses will provide details of the money managers and chief executive officers earn

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 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 60 lakh. As on 1 March 2016, your portfolio value would be 1.46 crore. As per rough calculations, your latest half-yearly CAS (as on March 2016) would have shown your distributor having earned about 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 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 42 lakh to 39 lakh. Now see your distributor’s commission. It went up marginally, from 18,936 to 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 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.