The story of upfront MF commissions

If you haven’t yet been approached by your mutual fund (MF) distributor—could be your bank or an independent financial adviser (IFA)—to invest in a closed-end equity scheme, in the past six months or so, you must be living on a different planet. The 10.13-trillion Indian MF industry appears to have gone into an overdrive in launching closed-end equity schemes. In 2014, 44 equity schemes have been launched so far and which have collected about 4,300 crore (leaving aside the Goldman Sachs Central Public Sector Enterprise exchange-traded fund that raked in 3,000 crore). In 2013, 27 such schemes were launched, and about 2,700 crore was collected. Most of these schemes have been closed-end.

To attract investors to closed-end funds, fund houses are paying high commissions to distributors (some are even throwing in foreign trips). In fact, commissions paid to some banks have reached 7-8% of what they mobilize during the new fund offer (NFO) period.

Mint did a survey among MF distributors and fund houses to get a sense of the commissions being paid these days (see table). Of a total of 32 closed-end equity schemes that closed for subscriptions this year, we analyzed the data for about 25, and a few open-ended funds as well, and then verified the results across 5 distributors and a few senior MF executives.

This is what we found.

• Most closed-end funds offer a base commission rate of about 4% to distributors. This is also the starting rate for IFAs, who are considered to be the smallest distributors. The commission is paid upfront at the time of getting money. For existing open-ended schemes, the usual rate is about 1.75% upfront (at the time of sale) and about 0.5% trail commission (per year) for as long as the investor stays invested.

• Banks, as distributors, get the highest commission, sometimes as high as 6.75-7%, upfront.

• These are just base rates. There are added incentives for additional mobilization.

• Some fund houses, such as ICICI Prudential Asset Management Co. Ltd, have incentivized distributors (an extra 1% or so) to get a commitment from their investors that they will re-invest their proceeds after a closed-end scheme matures into an existing open-ended fund of the fund house. Mint has reviewed one such communication.

• Some fund houses run contests, and offer extra. For instance, Reliance Capital Asset Management Co. Ltd offered gift vouchers, mobiles phones or tablets, and even a foreign trip, to certain IFAs, depending on their collections, under a contest called “Udaan” (which is ‘flight’ in English). Mint has reviewed one such communication.

Last week, at the Association of Mutual Funds of India’s (or Amfi, a trade body) annual general meeting, the Securities and Exchange Board of India’s (Sebi) chairman, U.K. Sinha, expressed concern about fund houses paying high commissions to distributors. A senior Sebi official said to us, “Sebi is watching the scene closely. Sometime back, we had asked for the commission data and we are monitoring this space. At this stage, we don’t wish to intervene. But if we find water going above our head, we will intervene.”

Future commission, now

Instead of the typical practice of paying upfront first and then trail commissions later, for closed-end funds MFs pay everything upfront since investors have to stay invested till maturity. This practice is called upfronting in MF parlance. The fund house dips into its own pockets to pay this, and then recovers the trail fees through the annual charges that it levies on schemes.

For instance, if a three-year closed-end NFO pays 2% trail fees for the first year, 1% in the second and third years each, it pays a total of 4% upfront. “These are just the base rates. Many fund houses give additional 0.5% to 1% if we meet certain conditions, like an additional 50 lakh or 1 crore. For the creamy layer of distributors, these conditions are often easily achievable. That’s one way of raising commission rates,” said a Mumbai-based distributor.

Banks earn higher commission on account of the huge amounts they can mobilize. Mint has learned that so far this year, of all the closed-end NFOs launched, banks have garnered about 42% of the total inflows, 32% came from national distributors and about 26% from IFAs.

Banks are also known to keep stringent targets for their relationship managers (RM). “Many banks tell their RMs to get earnings equivalent to five times their salary. So, if my salary is 15 lakh a year, then I am supposed to earn an income (commission) of 75 lakh for the bank through sales of various products, including MFs. Only if the earning is more than 75 lakh will I, the RM, get a bonus,” said a private bank’s RM on condition of anonymity, adding that the second year’s trail fees earned on these investments are not counted in this bonus formula.

Open-ended funds catch up

As high upfront commission can be paid on closed-end funds, open-ended schemes have increased exit loads. High exit loads nudge investors to stay invested for longer periods. And since investors tend to stay longer—though exit loads do not completely stop people from leaving—fund houses can also pull up the trail fees of subsequent years and pay it as upfront fees. Here’s how it works.

Say, an open-ended scheme pays 1.75% (of the investment value) as upfront commission. Its trail fee structure is like this: if investor stays invested for one year, 0.5% is the trail fee in the first year, and 1% for every subsequent year she stays invested. Typically, the upfront fees comes out of an AMC’s pocket and the trail fees from the annual scheme charges, every year. Now assume that the exit load of this scheme is levied for withdrawals before a year. If the investor chooses to leave after a year, because she wants to avoid paying exit load, the maximum that the MF can give to the distributor through upfronting is 2.25% (1.75% upfront fees + 0.5% first year trail fees). As the exit load nudged the investor to stay beyond a year, the AMC knows that it will make money (annual charges) on that investment at the end of the first year. It, therefore, chooses to dip into its own pockets and pay the trail fees and then recover it from the scheme’s annual charges it will receive from the scheme later. Also remember, the AMC can pay an advance to the distributor against a future income it knows it will surely receive.

Faced with competition from closed-end funds, open-ended funds, too, are nudged to pay higher upfronts to distributors. What does an open-ended scheme do? It makes sure that investors stay invested for as long as possible, so that there is income surety, and the AMC can use its own money to pay higher commissions. Let’s say that the fund has stretched its exit load period to two years. Assuming that the investor would now stay invested for two years, the AMC can now pay the second year’s trail fees, upfront. So, the distributor gets 3.25% (1.75% + 0.5% from the first year + 1% from the second year).

According to Value Research, an MF tracking firm, more than 50 equity schemes have raised the period before which exit loads will apply—from a year earlier to about a year-and-a-half, to even two or three years. In simple words, you need to stay longer in the fund to be able to escape paying exit loads.

“The competition is tough; the fund houses that have so far stayed away from launching closed-end funds, feel the pressure. So, they are forced to hike exit loads to be able to offer slightly higher upfront commissions than usual,” said the head of a mid-sized fund house.

Do closed-end have a rationale?

Fund houses and distributors that sell closed-end funds claim that they are able to instill discipline by locking investors’ money for the scheme’s tenor. “In a closed-end format, you can execute a small- and mid-cap strategy better because the fund manager doesn’t have to bother about large redemptions,” said the president of a Mumbai-based distribution firm considered to be among the largest in the private wealth space. He added that of the total amount collected by his firm through MF sales so far this financial year, closed-end funds formed 9%.

Prateek Pant, executive director, products and services, RBS Private Banking, disagrees. “That’s where our role as advisers comes in; to be able to convince investors why long-term investing works, why funds with long-term track records are important, and so on.”

“A total of 103,000 folios were created with us across closed-end products launched since November 2013. Of these, about 45% are unique investors,” said Nimesh Shah, managing director and chief executive officer, ICICI Prudential AMC.

“The lock-in could be dangerous. Say, you had invested in a three-year closed-end fund around November 2005. Your fund would have matured in November 2008, and you would not have been able to withdraw when the markets peaked in January 2008. You would have had to wait till November; by which time, the damage would have been done to your portfolio. Open-ended fund investors could have redeemed in January 2008 itself,” said another distributor we spoke to.

As the survey is based on information that various distributors, IFAs and fund houses shared, and which is not easily available in a public forum, we took the opinion of MFs.

We sent emails to all the fund houses named in our table. Here are some of the responses. “We at Sundaram would like to keep the brokerage structures confidential as that is a private matter between the AMC and its partners. Hence, from our side, we have no comments to offer”, said Sunil Subramaniam, deputy chief executive officer, Sundaram Asset Management Co. Ltd, through an email.

Birla Sun Life Asset Management Co. Ltd, IDFC Asset Management Co. Ltd, and Reliance Capital Asset Management Co. Ltd did not respond. Only JP Morgan Asset Management Co. Ltd confirmed its figures. L&T Asset Management Co. Ltd confirmed its commissions paid on L&T Business Cycle Fund but said its commission on L&T Emerging Businesses Fund is “lesser than 5%”. A UTI Mutual Funds spokesperson responded over email saying that “the brokerage is significantly lower than the number you have indicated in the mail”.

ICICI Prudential AMC said said, “ICICI Prudential AMC has a policy of reasonable remuneration for its channel partners. For example, the peak rate brokerage for ICICI Prudential Value Series-3 and ICICI Prudential Value Series-4 was 4.5%. For Dividend yield, it was 2.75%. The peak rate brokerage paid on ICICI Prudential Tax Plan is 4.5%.”

It’s one thing that some of the recently-launched closed-end schemes have done well so far. But past performance is no guarantee of future returns. And though a closed-end product may instill discipline, it’s unhealthy for investors and, therefore, eventually the MF industry, if high commissions become the major reason behind the surge in closed-end schemes.