Mumbai: The trade body that represents the interests of the mutual fund (MF) industry has proposed that asset management companies should scrap paying upfront commissions to distributors and instead pay them in a staggered manner over the period an investor chooses to remain invested in a fund.

Board members of the Association of Mutual Funds of India (Amfi) on Friday agreed unanimously to move toward what is known in MF parlance as an all-trail model, following a warning from the capital market regulator to take corrective steps to deal with a sharp rise in commissions paid to distributors.

As Indian stocks rally to record levels after a long gap, commissions paid to distributors have risen to as much as 8% of the sum invested, with asset managers competing to tap retail investors making fresh investments in mutual funds.

This prompted U.K. Sinha, chairman of the Securities and Exchange Board of India, to caution MFs against paying irrational commissions to distributors, saying this would encourage mis-selling of investments and harm investors. Sinha was speaking at the annual meeting of Amfi last month.

“Since investors are coming into mutual funds after a long time, there is absolute madness in getting customers. Distributor commissions have reached ridiculous levels. Some fund houses have been known to paying as high as 8% upfront charges in their tax-saving equity schemes," said the chief executive of an asset management company, requesting anonymity.

“The mutual fund industry cannot sustain paying such high commissions," he said.

Friday’s board meeting was attended by only about seven of the 15 members of the Amfi board (comprising chief executives of large, mid-size and small fund houses) and Hoshang N. Sinor, chief executive of Amfi, according to Sinor. He is expected to call another board meeting of all 15 members this week to discuss the matter further and develop a consensus. Amfi will then reach out to all asset management companies and prominent distributor associations across India.

“It doesn’t bode well for the industry that the regulator has to step in every time to correct a situation. I think it is also the industry’s onus to take stock and behave properly. If something (high commissions) leads to mis-selling, they’re not worth it," said Sinor. “Unless and until all stakeholders participate in this debate, this may not work out. The sentiment has improved and investors are now again putting money in MFs, so it is for the industry to take the obvious next step and clean the system."

The MF industry should move toward an all-trail model of commissions within the next three months, he said.

Typically, fund houses pay commissions when distributors bring in collections. They also pay so-called trail commissions annually to distributors for as long as the investor stays invested. Since fund houses have been mostly introducing closed-end funds that have a fixed maturity period, they have been paying distributor fees upfront. Every year, schemes are allowed to charge investors as much as 3% of weekly average net assets. Of this, the fund house pays about 1-2% trail fees to the distributor as long as the investor stays invested. Since closed-end new fund offers come with a lock-in of three-five years, fund houses prefer to pay upfront the trail fees that it knows will accrue over the scheme’s tenure.

Most closed-end funds offer a base commission rate of about 4% to distributors. This is also the starting rate for independent financial advisors (the smallest set of distributors). Banks, as distributors, get the highest commission, sometimes as high as 6.75-7%, upfront. These are just base rates, and can rise further if the distributor fulfils certain conditions.

“When distributors get 7% commission upfront, they will forget everything and just push schemes blindly, without bothering to understand whether the customer needs it or not," said the chief executive cited above.

It also hurts the asset management company’s finances. Every time a fund house pays the commission upfront, it has to do so from its own funds as trail fees are earned on a year-on-year basis.

“It is very difficult for smaller fund houses to launch NFOs (new fund offers) and match high upfront charges. An all-trail model is beneficial to not just fund houses, but also investors, as it reduces mis-selling," said the chief executive of another asset management company. He too declined to be named.

To be able to match the high upfront charges that closed-end schemes have been paying, open-end schemes too have been forced to raise their commissions. They do this by increasing exit loads (charges imposed if investors withdraw prematurely). More than 50 equity schemes have lengthened the period before which exit loads will apply—from a year earlier to about close to two-three years now, according to Value Research, an MF tracking firm.

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