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Commentary

In Defense of High Commissions

Suresh Sadagopan questions SEBI’s regulatory actions in his article. (HT: Srikanth Meenakshi)

By focusing only on investor interests and making the business an unviable proposition for fund houses and distributors, Sebi is actually harming investor interest in the long run.

As per estimates, only the top 10 MFs or so will be profitable as their margins shrink. Compounding this, distributors deserting  mutual funds for greener pastures, moving on to insurance, debt products and real estate. AUMs are not growing; equity AUM has actually declined since August 2009.

What went wrong?

Sebi has been focusing on the charges aspect alone and has been trying to whittle that down. That is a very lopsided approach. For example: The latest move to curb any payouts except from expenses has got the MF industry pinned against a wall. The fund houses now can only pay out of their own pocket, which means the must suffer losses or pay out what is possible from the recurring expenses account.

Also, while distributors cannot hope to earn in MFs, all other spaces in financial services were not similarly hamstrung.

Distributors of debt products including Public Provident Fund, National Saving Certificates and fixed deposits, etc, get about 1%. Commission on insurance products can be in double digits. This is what caused distributors to beat a retreat from MFs.

I disagree that the proposition is unviable – it is only short term unviable until the AMCs scale. They need to get to their customers directly and make their products saleable even over the counter. And distributors CAN charge clients directly for their service. Yes compared to other products which pay them a fee, they can get by with lesser.

Also PPFs/NSCs pay the 1% from their fees – “out of their own pockets”. (they don’t cut it from you, remember) so in the same way AMCs can take the money from the fund management fees (upto 2.5%) that they charge.

Every industry depends on intermediation. Take retail. The size of the retail industry is about $450 billion. Retailers make margins of anything from 10-70%. Assuming the average is about 20%, the intermediation cost is $90 billion, or about Rs 4.2 lakh crore!It would be great if we didn’t have to incur this cost, right? After all, we all have to pay this price. Still, we pay it.

Thus, intermediation is a value-add; not just a cost. It is a service and any service needs to be paid. Vilification of the service provider and making it unviable to operate will only create an undesirable vacuum.

The comparison with retail is crazy. You buy retail products for consumption, mutual funds are investment. You don’t buy a book to sell it back – if you did, you would definitely be bothered with any intermediation costs.

Take term insurance for instance – I don’t care what commissions are paid, it’s a product I buy for consumption (rather, it’s an expense). But investment product commissions directly impact the goal for my purchase, that is, to make the value go up; I have no other use for the product. Commissions cut into that goal, so I must work to reduce them. And when misselling by not informing customers about commissions becomes rampant, the regulators must get involved. 

And there are value addition and logistics charges. For instance, buying a book online may cost me shipping charges of say Rs. 20 per book. If I’m ok with that, I’ll pay the shipping (and I’ve paid tons to Amazon to ship books to India); if I think I can do better by going to a bookshop or contacting the publisher directly, I can do that. Or I can pay the retail price, because I value the book at that much. Bookshops also have inventory cost, and return costs. That I understand is value I pay for. 

There’s no such thing with mutual funds; distributor value addition is largely form filling and transport! For that, I should pay 2.25% of AUM? Or even 1%? That is silly. If he gives me good advise I don’t mind paying him separately, and I can value that right – so it shouldn’t cost me more for 2 lakhs versus 1 lakh.

What distributors should do is charge their costs separately, then I can value it appropriately. The comparison with retail is a sorry excuse for looting customers.

(Let’s not get ad-hominem and say that the author, Sadagopan, is a financial planner, please. Attack the argument, not the arguer)

  • Soham Das says:

    >You buy retail products for consumption, mutual funds are investment. You don’t buy a book to sell it back – if you did, you would definitely be bothered with any intermediation costs.

    How do you draw the line between an investment and consumption. You buy, soap because its useful to your health needs, you buy MFs because its needed/useful for your wealth needs. You consume the service of mutual funds, whats wrong with it?And pay a commission for it.

  • Deepak Shenoy says:

    >Big difference, Soham. Soap is consumed; it has a use by itself. You can't do anything of any value with a mutual fund – it's a piece of paper, or worse, a demat statement, nothing more.

    Even real estate has a use, you can live in a property. People still focus on keeping commissions small there; because it has an investment side also.

    On the investment front, you want to keep commissions low. If you value advice, pay for that advice separately, not built in to the mutual fund where everyone, even those who don't want advice, have to pay for it.

  • Anonymous says:

    >I have an in-between take on the entry load ban on MFs. The problem that needed to be addressed was the commissions, distributor/agent incentives not aligned with the investor, etc.

    That should have been addressed directly and that would have taken care of the loads issue by itself.

    Instead, what we got was a diktat on business expenses and what happened was all funds moved to introduce exit loads and increase their expense ratios. This was a sub-optimal result and investors did not get all the benefit of a no load system.

    Instead, I think funds should be left to charge whatever they like as long as they have a market that pays them. What should be restricted/reoriented is the distributor role. The regulator should improve transparency of commissions paid by MFs at the point of purchase, encourage competition by encouraging low cost sector etfs, encourage financial literacy by including comparisons to benchmarks perhaps, etc.

    The net result would be what was desired in the first place – lower/non-existent commissions for distributors, most MFs reducing costs naturally due to competition (while some who claim true alpha could maintain higher costs if they could) and improvement in financial literacy by improving agent incentives, etc.

    I don't like SEBI riding in as a white knight to save the investor and banning x, y, z expense. I think if it makes x, y, z expense obvious and transparent to the investor it solves the problem in a cleaner way and improves the chances of a natural adjustment in the market.

    So, I'm all for reduction in commissions, expenses – I am a retail investor after all. But, I would have liked it to have been the result of healthy competition among free businesses. Reduction of costs by diktat is good but second-best.

  • Srikanth Meenakshi says:

    >Deepak,

    Just one point:

    Agree that the comparison with regular retail does not hold water. However, the comparison that you make with deposit products is not valid either. The way deposit houses make money on the "other end" of the deal is not comparable to how mutual funds make money. In case of deposits the money gets deployed on a "rate-of-return" basis on the market and this rate of return can be tuned with respect to the total cost of borrowing (interest plus commission) and a reasonably quantifiable risk quotient.

    In the case of mutual funds, the money gets deployed on the "other end" in the market which does not guarantee any return. And whatever return comes about needs to be recorded and paid back to the investor (unlike in a deposit product where only a previously committed rate needs to be paid out). Hence the entire cost of servicing the customer – be it fund management fees, distribution fees, servicing fees, or cost of the chaiwallah – needs to come out of the investment corpus. To say that all fees except distribution fees can come out of the corpus but distribution needs to get paid separately is not fair. Transparency is one thing, but that does not equate to making the distribution services totally dispensable.

    Agreed, there was rampant mis-selling, and what is SEBI doing in terms of cleaning house in that regards is welcome. But let's not throw the baby out with the bathwater.

  • Deepak Shenoy says:

    >Anon: It's been tried – even now distributors are mandated to reveal commissions for each transaction, but they simply don't. Even the online fellows give random numbers like "between 0.5% to 1.5%".

    Banning certain expenses and how accounting should be done, etc. are overkill, perhaps. But the industry has just not responded to nice regulation. Worse, the insurance companies are HORRIBLE, and the mutual funds are doing what they can to match those commissions. I have a feeling that is the root cause; Fix the insurance issue and everyone will behave?

    It's a little like TRAI. Sounds seriously anti-industry but it's a booming, growing industry today because of the low costs…

  • Deepak Shenoy says:

    >Srikanth: The deposit products are straightforward; i give you X return, and I take the risk that I can't get that return from the market. If I get a premium return, I keep the extra. I can pay out of that – and I can ONLY pay out of that. Your Rs. 100 invested, is Rs. 100 invested, nothing less. (Entry loads were the opposite)

    Coming to mutual funds – you are confusing distribution fees and advisory fees. Distribution fees CAN come out of the corpus, as trail loads, paid on a monthly basis (Fund NAVs deduct management fees DAILY, dammit, they can even pay you daily if they want) THis is all covered in the total 2.5% cost.

    As I mentioned there is little cost in distribution; paper form filling and filing with CAMS/Karvy, that's it. If Karvy/CAMS can process all those forms for a microscopic charge, distributors can be happy for the distribution charge (which is usually 4x or 5x the CAMS charges)

    Advisory fees are different. If your customer values the relationship and value-add you provide, they should be willing to pay you. If not, there is no point in hiding the cost; do not service them, simple. If they can't find a distributor to help them, they'll come and pay you if you're the best.

    Right now, we are overvaluing the baby out with the bathwater bit; yes, SEBI's posture is tough, but we'll all do well if we pay heed to what they want (no load products, no misselling, no misrepresentation, no overcharging)

  • Anonymous says:

    >Deepak, maybe you are right but I'm not convinced that it has been tried properly.

    What if SEBI put the onus on the MF to disclose the commission in individual investor statements?

    Insurance is horrible yes although I don't have much experience with it (I should!). Maybe fixing insurance improves the overall standards. I saw your Ulip example with the schedule table. What if IRDA said that the expected commissions over all years should be printed out and given to the investor and signed before the Ulip is sold?

    SEBI has put their mind to it and perhaps they selected the best option. I am still uncomfortable with a diktat mode – I dunno about overkill but it seems sub-optimal to all parties concerned.

    IRDA ofcourse is worse than SEBI and my comments are specific to the SEBI ban on entry loads only.

  • Srikanth Meenakshi says:

    >//Coming to mutual funds – you are confusing distribution fees and advisory fees. Distribution fees CAN come out of the corpus, as trail loads, paid on a monthly basis (Fund NAVs deduct management fees DAILY, dammit, they can even pay you daily if they want) THis is all covered in the total 2.5% cost. //

    OK, I understand your position better. I think there is little daylight between our assessments.

    thanks,

    Srikanth (FundsIndia.com)

  • Anonymous says:

    >"On the investment front, you want to keep commissions low. If you value advice, pay for that advice separately, not built in to the mutual fund where everyone, even those who don't want advice, have to pay for it."

    On your response to Soham, well why should commissions *always* be low? You do know that some MFs are active management vehicles and that they should be able to charge for alpha if they can generate it? If you don't want the advice of the MF manager don't buy it and buy a low cost etf or a low cost MF that tracks an index.

  • Deepak Shenoy says:

    >Anon immediately above this: There are vehicles for that called PMS. They are only sold at 5 lakhs or higher investment, and can involve ANY level of commissions. The funda being that the richer folks can afford to lose their money, and the richer will do more diligence. I don't necessarily agree, but that seems to be the way even hedge funds are managed in the US. (Though in the US, there are CTA models where advisors for lower amounts can charge a fee and are regulated, India should do that too)

    Remember PMS is not pooled investment. Each trade is in the customer's own account. Therefore the collective investment rules do not take effect.

    Mutual funds are slightly different – they are pooled and marketed to anyone, and therefore the message can get lost in tricky wording or because advisors take advantage. MFs worldwide are not allowed to charge on alpha (I think).

    Plus in India there is a tax advantage. Imagine I start a mutual fund, and trade in shares (buy/sell within the year). MFs get charged no capital gains tax. The gains I distribute as dividend. Again, no dividend tax on equity funds. (this applies even with the direct tax code, btw) Voila – a tax free gain! The downside is that funds aren't allowed to charge on alpha, and funds are deeply regulated, have to announce portfolios, turnover ratios etc. So given that advantage, which is arbitrary, there are arbitrary disadvantages like the 2.5% max commission limit.

    You are free of course to not invest in mutual funds, if you want to pay higher commissions. There are many insurance agents that would kill for your email address 🙂 Just kidding – you're a more informed investor who doesn't need regulation; and there are ways around that like the PMS I mentioned.

    One other thing that can be done if one wants to charge for alpha, legally, is to set up a company or LLP, where equity is put in by investors and a manager who also has equity in the LLP, manages the fund. This can't be used by more than 50 people, but it is legal and SEBI has no jurisdiction (unless you advertise or guarantee returns)

  • Anonymous says:

    >As soon as I posted my message I wanted to take it back because I mistook commissions for management fees. 🙁

    MFs in the US are now offering quant strategies and strategies like 130/30 and I used to think that its good in the sense that there are some people who know what these strategies are about but don't have enough money to go to hedge funds so they can benefit. Anyway….

  • Anonymous says:

    >Deepak

    I dont think you really understand the distribution business well. Incidentlaly i am a retail investor.

    1) On your comparison of PPF/ NSC to mutual funds – The right comparison to do would be to do with a debt mutual fund product. If u were to do that comparison the the commission paid on a debt product by a mutual fund is lower than a ppf/ nsc.

    2)Have you ever asked how much of the commission gets passed back to the investor as payback. Though this is banned, most retail investors expect a payback. Ask any distribuor any they will tellu on this. Of course no retail investor will tell u this 🙂

    3) In India we are not tuned to pay for advice. We love everything for free. A retial investor will come and sit for an hour and discuss about the market without valuing the distributors time. Ask him to pay per hour charges and u will see him disappear. That is the cost a distributor has to incur. Do that in IT and u will see a per hour bill coming to you. Its very nice to demonise the distribution faternity and there are lot of bad apples but investors also dont coming smelling of roses.

    4) Also u r not factoring the cost of servicing. Do u think investors after investing go and do their own redemption or solve their own queries. It all lands on the distribution. I was chatting with a distributor friend of mine where he was forced to submit 50 letters to various fund houses to shift names ina folio bcos of death of a individual. Do u think the indian investor pays for this service?

    5) I find u r arguement of retail being comsumption and MF being investment as random. A cost is a cost. I would want to reduce it whether i buy a soap or a MF. So u r saying a C&F agent or a shokeeper / retailer can charge me 7-8% as distribution costs but a MF advisor is immoral to do that ????. cant figure this one out.

  • Work_ant says:

    >And the other problem is investor profile – most mf/ulip investors equate it with either equity or fd. One reasons NFOs do well as people have a notion of listing gains etc aka IPO.

    In this environment, the regulator should endeavour to keep the product simple so comparisons do not need algorithms etc. If everything is in the Management charges it is easier. The question is should the management charges be capped at all? May be not, but given that the industry behaves like an oligarchy maybe yes..

  • Deepak Shenoy says:

    >Anon: 1) PPF to MFs – remember the commission on PPFs is one time; 1%. The commission on debt MFs can be 0.5% to 1% upfront, and then 0.25-0.5% per year. Take that over the life of the deposit (NSC three years, PPF 15 years) and you'll find the commissions are low. More importantly, it's not how much but the method that matters – the PPF issuer gives the commission out of his own pocket, not through cutting investors investment. MFs can do the same thing and recover it from the investor, pay the distributor back-ended etc.

    2) and 3) Yes, the investors are to blame too but you can change that easily by refusing to service them unless they pay you a fee; they are just demanding the lowest costs, SEBI is saying that is unfair, but don't build the cost in the product, bill it separately.

    4) Indian investors DO pay for service. When you pay delivery charges for books, it's a separate charge. When you pay for airline tickets the service charge is separate now; and you pay it. Even though these are consumption goods, you pay them. Then why not for investment products?

    5) I've said what I feel; consumption costs are different, investment costs are different. People can cut consumption costs by going upstream if they desire. They can't do so with fees built into the product for investment products. Even the MRP for retail is a max price; you get products way below MRP as well.

    Think of retail loans; you get a loan, you pay "processing fees", those are commissions and you pay them separately. Early repayment fees, late payment fees are also billed separately. They are not part of the product and negotiable. Why not do the same with MFs? That's where SEBI is at now.

    Having said all this I believe investor attitudes need to change. But I believe they will as people get smarter – either they will do their homework and cut out the distributor, or they will pay distributors for service and advice separately. For this there is short term pain, no doubt.

    WOrk ant: Well said. capping mgmt charges is perhaps because of earlier misuse but putting everything inside a single charge is better.

  • Anonymous says:

    >- I have to half-agree with him about disincentivisation using 0 entry load for distributors. Because a guy in a village or zero investment knowledge is not going to invest in MF unless somebody tells him or guides him. He will never get equity exposure and benefits. If there is 1% entry load it is incentive for distributor to sell it. Also current model of "pay 2.5% for my service" will not work well, because of investor psychology (eg 2500Rs for 1lakh investment and 5000 for 2 lakh etc, if investor pays knowingly everytime as service charge, he will get discouraged . He asks ,"I pay 200Rs for doctor consultation, why should i pay 2500Rs for finance consultation of a single MF and pay everytime for any investment I make) . If it is via entry load, he wont know. By giving distributor an incentive, people will get some equity exposure and benefits. Else financially ignorant people always gets into to FD,nsc etc and no equity exposure which will give better returns long term.

    – But yes, no-entry load greatly benefits people like me (ie with little bit finance knowledge). I do research on sites like valueresearch and buy the funds i like online via hdfc a/c. No entry-load is cool for me!.

    – But anyway with lopsided commission of ulips, I think no distributor in his senses anyway will recommend MF. He will recommend ulip only. Hopefully when Sebi regulates ulips, it will become level-playing field.

    – One of his question there is "why now?" ie why sebi tries to regulate Ulips now and not all these years?
    – His question is meaningless. Better now than never, I say. The insurance regulator didnt bat an eyelid all these years when ulips look 50% commission (looting). Now at least sebi takes charge. It will greatly benefit the current and future investors.

    [ Note : I am not a distributor, just a investor and in IT field ]

  • Deepak Shenoy says:

    >Anon: Only one question – do you think it's a good thing for the rural investor to get equity exposure without any financial knowledge of risk or reward? If he doesn't know, he shouldn't get the advantage; let him learn and then take it up. And we can work on education (SEBI can even initiate educational sessions).

    Perhaps financially ignorant people should get financially ignorant style returns as well, that will at least force them to try and learn about what else is available? If they learn and find out the field is full of con-job distributors taking big commissions – look at the general distaste towards ULIPs by people who have figured out the comissions – they will never invest.

  • Priya says:

    >I would really like to know how many people, and by people I mean retail investors, would pay for investment related advise. There are costs that are incurred by the distributor/agent to have a decent set-up for servicing clients. But our mentality for free stuff has to change before we move from a commision-based structure to a fee-based one.

  • Deepak Shenoy says:

    >Priya: Airline agents said the same thing as airlines cut commissions to zero on the ticket. Agents were supposed to charge a service fee separately, which they do now. It's gotten accepted, even in a domain where the product is a consumable (not a tradeable).

    People pay for advice all the time in the stock broking industry; brokerage is billed separately and negotiated. Companies charge some Rs. 500 a month to Rs. 5000 per month for tips and trading ideas.

    The fact that we've always gotten it for free doesn't mean people won't pay for advice. The best way to ensure people pay is to not service them if they don't pay – as simple as that. It's a short term pain point, but in the longer term it will benefit everyone.

  • Anonymous says:

    >Agree with Deepak and SEBI. Lets not forget that the advise is not 'free'. There are trail commissions to the tune of 0.5-1% that the distributor anyways gets which should compensate him for the costs.

    The SEBI stand (and the standoff!) is already having an impact (small currently) on IRDA where the rip off on the ULIPs is now being whittled down a bit