Why you should worry about the cut in mutual fund distributors’ fee
With AMCs passing the expense ratio cut to distributors, the latter may churn investors for higher feesThere is wide variation in the commission structure of various schemes and mutual fund houses
PremiumAt a board meeting on 18 September 2018, capital markets regulator Securities and Exchange Board of India (Sebi) cut the maximum total expense ratio (TER) that mutual funds can charge. Maximum expense ratios were set for funds based on their size. For example, an open-ended equity fund with assets under management (AUM) up to ₹500 crore cannot charge more than 2.25% as expense ratio, while an equity fund with assets between ₹500 crore and ₹750 crore cannot charge more than 2%. The regulatory rationale was that costs do not increase in proportion with size and, hence, the benefits of economies of scale should be passed on to the investors. The impact of the cut in expense ratio could be shared between the asset management company (AMC) and the distributor.
However, in practice, large AMCs seem to have largely passed on the cut to mutual fund distributors rather than absorbing it themselves. Small distributors and independent financial advisers (IFAs) have been hit the hardest. According to Sebi, as of 28 February 2019, there are 124,000 mutual fund distributors in India.
Impact on distributors
TER is an aggregate figure that includes all types of charges and fees. It is expressed as a percentage of a scheme’s assets. To take a simplified case, a scheme with a ₹1,000 crore size and a TER of 2% will be able to charge expenses of ₹20 crore per annum. Certain expenses such as additional expenses for AUM outside the largest 30 cities fall outside this figure.
“TER consists of distribution expenses and other management expenses but the total TER reduction is passed on to distributors," said a letter issued by the Amritsar IFA Forum sent to a multitude of fund houses, including IDFC Asset Management Co., SBI Funds Management Pvt. Ltd and Tata Asset Management Ltd. Another letter from the Foundation of Independent Financial Advisors (FIFA), sent to ICICI Prudential Asset Management Co. and HDFC Asset Management Co., also raised the issue of passing on the cut to distributor commissions. MFD Universe, a mutual fund distributor group, too, sent a letter to HDFC AMC, stating that the commission offered to distributors in most cases is lower than the differential between regular and direct plans.
“There is a squeeze on distributor commission in the range of 20-30% of their income. The entire ecosystem will get affected. IFAs will be impacted the most as their business model of serving retail clients will take a huge hit," said Nishith Baldevdas, founder, Shree Financial, a Chennai-based IFA. Amol Joshi, founder, Plan Rupee Investment Services, a financial planning firm, pointed out that old investments made through distributors which had a model with upfront commission and trail commission have been hit particularly hard. “Very old assets have relatively low trail and even this low trail has been cut," he said.
Impact on investors
Three distributors, who spoke to Mint on the condition of anonymity, said this could lead to higher churn for investors of mutual funds. “Some distributors may switch investors to schemes with higher commissions," said the first distributor, whose business is based in Chennai. The second distributor, who is based in Mumbai, raised concerns about the incentives such a move would create for some distributors to sell competing products such as unit-linked insurance plans (Ulips) that are high on commissions.
There is wide variation in the commission structure of various schemes and fund houses. A disclosure of commissions (April-June 2019) made by Standard Chartered, a bank which distributes mutual fund products, captures the disparity. For example, Edelweiss Balanced Advantage Fund offers a commission of 1.40%, while Tata Balanced Advantage Fund offers a commission of 1.70%, even though both fall in the same hybrid dynamic asset allocation category. The former has an AUM of ₹1,400 crore, while the latter has an AUM of ₹798 crore, which puts them in the same Sebi expense ratio band of funds ranging from ₹750 crore to ₹2,000 crore. In comparison, ICICI Prudential Balanced Advantage Fund, another fund in the same category with an AUM of ₹29,033 crore offers a commission of 0.85%. From a distributor’s point of view, there is a strong incentive to switch to a scheme with a higher commission structure.
Investors should note, however, that commissions change from one distributor to another based on their bargaining power. In this example, we have taken Standard Chartered as a proxy for medium to large distributors. Smaller distributors may get a much lower share as commission.
Commission Structures
The expense ratio of a regular plan minus distribution commission equals the expense ratio of a direct plan. AMCs have argued, on the condition of anonymity, that a reduction in the expense ratio of a regular plan through a cut in distributor commission leads to no change in the direct plan expense ratio. Let’s understand this through an example. If the earlier ratio for a regular plan was 3% and direct was 2%, the commission would have been 1%. If, post Sebi regulations, the ratio for regular plans had to be brought down to 2%, half of which came from a commission reduction, the result would be a reduction in regular plan expense ratio to 2%, commission from 1% to 0.5% and cut in direct plan expense ratio from 2% to 1.5%. In other words, only half the cut is passed on to direct plan investors. However, an absorption of the cut wholly by the AMC benefits both regular and direct plan investors. This is a choice exercised by the AMC in question.
A Mint analysis of the gap between regular plans and direct plans of schemes for 14 of the largest equity and hybrid funds shows that distributor commissions fell from 0.97% to 0.73% of the investor’s corpus on average. Note that commissions for debt funds tend to be even lower.
Despite the cut in commissions, the industry pushback is that this hasn’t impacted distributors’ businesses in a big way. In fact, one of the larger AMCs in India shared some data with Mint, on the condition of anonymity, pointing out to the growth in businesses for IFAs over the last three financial years. Data from the AMC pointed out that the top 500 IFAs took in an aggregate commission of ₹1,522 crore in FY17-18, and other IFAs took in a commission of ₹393 crore, taking the total IFA commission to ₹1,915 crore. This accounted for just 22% of the total commission pie in FY17-18 of ₹8,534 crore with banks accounting for 42% of the commissions and national distributors accounting for 35% of the total commissions. However, despite the relatively low share, the top 500 IFAs had grown their commission by 175% compared to FY15-16 and other IFAs had grown their commission by 251% since FY15-16, the AMC pointed out.
Mint emailed two of the largest AMCs in the industry, HDFC AMC and ICICI AMC, to ask whether distributor commissions had been indeed reduced instead of costs to accommodate the cut in expense ratios, but none of them responded till the filing of this report.
Mint take
Distributors are an important part of the mutual fund ecosystem. The TER reduction by Sebi was made on the grounds of economies of scale. In other words, managing assets of ₹5,000 crore does not cost 10 times more than managing assets of ₹500 crore and, hence, schemes with higher assets should have lower expense ratios as a percentage of scheme assets.
By passing on a bulk of this reduction to distributors, AMCs seem to have negated this logic. “The TER cuts must be passed on in an equitable manner with both AMCs and distributors taking a proportionate hit. AMCs should be mindful that commissions on direct plans also decrease because ultimately all active funds are seeing strong competition from passive ETFs (exchange-traded funds) where expense ratios are much lower," said Suresh Sadagopan, founder, Ladder 7, Financial Advisories, a financial planning firm.
AMCs need to work with distributors to create a win-win business model.
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