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Business News/ Opinion / Being upfront on commissions
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Being upfront on commissions

If high commissions are tackled, then the nuisance of upfronting can also reduce, significantly

Shyamal Banerjee/MintPremium
Shyamal Banerjee/Mint

It’s been close to two months now since the Association of Mutual Funds of India (Amfi) proposed the idea of abolishing upfront commissions that fund houses pay to distributors. The idea was mooted at that time on the back of media reports about high levels of commissions that some new fund offers (NFO) of closed-end funds were paying to some distributors. The debate is still going on. Amfi’s board, which consists of chiefs of 15 fund houses, too, met on 14 November (some members were absent) to take the discussion further but no final decision was taken. The board is to meet again in December to make up its mind and come up with a roadmap.

This column has always been in favour of an all-trail model, as against the present day model of a combination of upfront and trail commissions. An all-trail model (with higher trail fees than what’s given now, and also to compensate the loss arising out of removing upfronts) rewards distributors who are able to retain their customers for long. At the same time, it dissuades churning; the longer the investor stays invested, the more the distributors earn.

Sample the gross and net inflows between the months of April 2014 till date (a golden period during which multiple NFOs that paid high commissions were launched) of some distributors that an industry insider showed me. He did not share the list with me so I can’t reveal distributor names. The figures are rounded off.

A large private bank’s gross sales was 1,500 crore; net sales were 600 crore. The difference between the two is outflows. A large difference, therefore, points to churn. Another similar bank’s gross sales was 4,000 crore, and net sales was 2,000 crore. A large foreign bank’s gross sales was 3,000 crore, net sales, 1,200 crore. A large corporate-backed distribution house’s gross sales was 700 crore, but net sales was just 50 crore! An all-trail model aims to correct this sort of churning.

For now, though, Amfi seems to have kept its plan to abolish entry loads altogether in abeyance as many board members opposed it. So a middle ground is now being discussed.

Most board members appear to have come around to thinking that perhaps upfront commissions should be controlled; that they should come down, if not totally removed.

But can finding a middle ground solve the real problem, or is it just a way to push the problem under the carpet? Does the problem lie in having upfront commissions (paying future commissions now), or that these are too high?

Amfi—collectively, and not individual member-wise—appears to think that high upfront commissions are a bigger issue than upfronting itself. Also, if high commissions are tackled, then the nuisance of upfronting can also reduce, significantly. One of the possible solutions that Amfi appears to be toying with is fixing the first year’s payout. Some chiefs of fund houses I spoke to said that perhaps the yearly commission could be capped at 1.5%. So, the total commissions that, say, a three-year closed-end scheme could pay is 4.5% (1.5% * 3 years), which could then be paid upfront to the distributor. The 4.5% may seem high, but is lower than the 5-7% upfront commission that some NFOs have been paying to distributors this year.

But the problem remains. Why should distributors (not all; only those who get enticed by NFOs) sell an open-ended fund and not a closed-end one that pays the next three years’ commission upfront? Should MFs pay future commission today? 

Some fund houses feel that a distributor’s fees that is due for a specific year has to be paid in that year only, and not in advance—in other words, trail fees. This way, distributors (again, not everyone) may not be enticed to sell closed-end funds at the cost of open-ended ones. More importantly, it also removes the bigger malice of large, cash-rich fund houses paying distributors out of their own pockets (at the time of upfronting) and then recovering from the schemes later. A large fund house is known to even borrow from banks to do this.

Trail fees should be paid as trail fees, even though investors in closed-end funds are bound to stay invested throughout the tenor of the scheme.

The other formula being discussed is that instead of paying a certain rate as trail fees, like 0.8% or 0.9% or 1% of the corpus, it should be paid as a percentage of the MF’s earnings. So, of the total expenses that fund houses deduct from a scheme every year, some portion can be for commissions. Say, a scheme’s total expense is 2%, and 0.40% of this is for sundry charges such as registrar and transfer fees, trustee fees and so on. What remains is 1.60%, or 160 basis points (bps). One basis point is one-hundredth of a percentage point. Since there is complete fungibility of how fund houses spend this income, they can pay 50% or 80 bps to distributors as trail fees and keep the balance as their own income.

Apart from this rate, it’s also debatable whether different classes of distributors—banks, national distributors and independent financial advisers—should be paid the same percentage or not. Mind you, the rate could be the same, but a well-performing scheme or large distributors stand to earn more on account of higher corpus they handle.

Yet another innovative solution is this: pay upfront commission selectively. Either pay only for retail inflows (this figure can be capped, say, at only inflows below a certain threshold, maybe 20,000 or 1 lakh or 2 lakh) or pay to distributors only during their first five years of business operation. In the second option, new distributors would get financial support, as fund houses and some distributors claim is necessary. It would also prevent banks (the biggest culprits in the MF churn game) and most national distributors from earning upfront commissions since most of them would have been in business for more than five years.

The idea is—as a friend always uses in her daily life—to move “forward, always forward". The middle ground doesn’t look all that bad, does it?

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Published: 03 Dec 2014, 06:16 PM IST
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