Home / Opinion / Industry practice will ensure an only-trail commission model

High upfront mutual fund commissions are back. My colleague Kayezad E. Adajania collected data on commissions paid on 25 new fund offers (of the 32 launched) in 2014 (you can read the story here: http://goo.gl/ea8zZD) and found two things. One, upfront commissions are back at top rates of about 8%. Two, commissions are paid according to the bargaining position of the seller. The individual financial advisers are the lowest in the pecking order and get the smallest commissions while banks appropriate the most.

A quick recap. The capital markets regulator banned upfront commissions embedded in the price of the mutual fund (of the 100 you invested, 2 would go as commission and 98 would get invested) in 2009. The trigger was the persistent churning of investor money by banks and other sellers. Churning is a well-established way to milk investor money to earn commissions when the money is invested and when it exits. In a rising market, investors ignore these costs, but become sensitive to it when markets fall. Sellers, however, continued to get front commissions but these were coming from the mutual fund’s own capital that would be later recovered from the expenses charged to the scheme. Mutual funds now charge up to 3% on equity schemes each year.

When the markets were down, there was limited investor interest, upfront commissions were about 75-100 basis points (bps) for equity funds and 50-75 bps for debt funds. But as markets have gathered steam and investors are keen to enter the market, funds are raising the upfront commissions to attract investors. One way they have done this is by manufacturing and selling closed-end funds. A closed-end fund ensures that the investor stays with the fund for a fixed period of time. A part of the annual expense ratio over the lock-in period is then added and paid upfront to the sellers—banks, corporate agents and independent financial advisers, or IFAs. This is paid out of the capital or other reserves of the fund. The fund recovers this money from the investor over a period of time.

So, why is there a problem if funds are using their own money to compensate sellers? The problem is that it skews investors’ choice towards hard-sold funds that may not be appropriate for them. For instance, if a small-cap fund has a higher upfront commission than a balanced fund, the seller is likely to push the small-cap fund to even a first time equity buyer or a person with lower risk taking ability and not the balanced fund. High upfront commissions also encourage churning.

The problem of getting sellers to do the right thing by the investors is not a problem unique to India; other countries have grappled with the issue of commissions driving sales. There is also a lot of academic work out there that proves that commissions do indeed drive sales. Two countries known for pro-active regulators in consumer protection in finance—the UK and Australia—have walked the entire journey from commissions to no commissions at all. Financial advisers must charge an upfront fee and receive no commissions—front or trail—from the companies in these countries. This has been done across financial products—funds, retirement plans, insurance products—with the aim of making products more transparent and to reduce the risk of mis-selling.

India is still at the second stage of this journey—we’ve banned upfronts in mutual funds from the investor, but not upfronts as a concept. The next leg of the journey (on a path that is not new; other countries have walked it) will see upfronts being banned altogether. This leaves me to wonder why Indian regulators want to walk the entire journey and not jump to the final stage. Of course, knowing that retail investors are unlikely to litigate keeps the costs of hurting them low for the regulators. And when all else fails, they can pass regulations that prevent investors from suing them three years after buying a product.

Endnote: If you have not yet heard the hour-long show titled The Secret Recordings of Carmen Segarra on the weekly US public broadcaster, This American Life (http://goo.gl/FHTiQ3), you must. As an external expert hired by the New York Fed and placed inside Goldman Sachs to regulate it, Segarra found what “complicit" regulators actually meant. The dark underbelly of weak and complicit regulators is now on tape. India is at the very inception of its regulatory thought process. I do hope we can get it right.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com.

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