Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Personal Finance

Why AMFI Should Not Ban Upfront Commissions

I am all for regulation. As in, I do not think a world without regulation, in the financial space, is worthwhile. But not all regulation is good, and the specific nature of my argument is that while I like the concept of regulation, I think we fail in the implementation.

Latest in my disagreement series is that AMFI is considering banning all upfront commissions to distributors by mutual funds. I think this is a bad step, and I think so even as I find it agreeable that we have no “entry loads” by regulation.

After our earlier post about Mutual Funds Hiking Exit Loads, we received notice that much of this is due to large upfront commissions demanded by distributors has gone up as much as 6% to 8%! This, ostensibly, is the reason why funds want larger and longer exit loads.

If you are a Capital Mind Premium member, you can access our report on how Mutual Fund Commissions have gone up in FY14.

Now, to attack the problem, AMFI wants to curb the “menace” of high upfront commissions.

But I think this is a terrible mistake. Let me explain.

You Supported the Ban on Entry Loads!

Yes, I supported the ban on entry loads. Why? Because I thought there was a large amount of misselling AND the customer was paying for these loads.

The extra load was a no-brainer for the fund house, and for the distributors; in Hindi, a phrase would apply which means “my father what goes?” (mere baap ka kya jaata hai)

This brought about industry collusion – all fund houses except two (Quantum and Benchmark) offered only full entry load funds. Entry loads were up to 2.25% and even had a 1% load for debt funds! These loads went directly to distributors.

The move to remove entry loads was good – this way, the customer doesn’t pay for distribution directly. If he desires to pay he should pay the distributors separately. It ensured that if Rs. 100,000 was invested, then Rs. 100,000 was invested into the fund rather than giving a part to the distributor and only investing the remaining.

How could funds compensate distributors? Out of their management fee. So one mechanism was to increase the management fee – which can’t go above 2.5% anyhow – and pay distributors more. Over time, upfront distribution fees were set between 0.5% and 1% for the most part.

In the same vein, I supported the creation of a “DIRECT” scheme for all funds – one where no commissions would be paid out. This allowed smarter people (readers: you) to buy funds directly and pay no commissions, even out of the management fees. These funds have done very well – many equity funds’ DIRECT schemes outperform the commission paying versions by 1% a year!

But Why is a Ban on Upfront Commissions Wrong?

Because the customer isn’t being held hostage. Mutual funds are, and they have the smarts and the ability to increase their spends and get to customers directly.

How does the upfront commission work now? It’s paid from a mutual fund’s AMC fees, by the mutual fund. If a fund decides it wants no profit and will pay out all of the fees to distributors, is that wrong? I think it’s fair, and no one is a dominating player in the industry for this to be a problem. The customer sees no impact.

Until now, of course, when funds are increasing exit loads. (For the record, I don’t want to see a regulation banning exit loads, because it’s not as bad as entry loads, and they are credited back to the scheme anyhow. It’s silly, but should not be illegal.)

Exit loads even apply on DIRECT plans as well, where no commissions are paid. (This is perhaps by regulation which might not allow no-exit-load only for the DIRECT scheme – in which case, the regulator should ease that bit)

My point is that funds are choosing to take a loss and pay these commissions. Let them. And let them hike exit loads within the overall limits. We allow retail players like Flipkart and Big Bazaar to offer huge discounts, even if that results in losses; we justify that by saying the customer is benefited and that’s a good thing. It’s the same concept here – the distributor gets a large commission, the customer gets to invest in the fund, and the mutual fund makes a loss. Nothing wrong with this picture, and if mutual funds want to cut off their own feet, should we intervene? (Remember, they are smart people, who can’t be misled)

As we’re seeing, none of the big mutual fund players are making a loss, so any defense arguing they’re losing money may be wrong.

In any case, the biggest distributors are banks. Ban upfront commissions and they will find ways to squeeze money out of mutual funds, using some other pretext (education and marketing cost reimbursements, until even those are banned).

At this point, however, the only party getting really harmed by upfront commissions are mutual fund AMCs. I fail to see why we need regulation to protect their profits; are we painting a picture that distributors are robbing them at gunpoint?

A ban on upfront payments would simply be too much regulation. Funds are capable of saying no, and increasing the reach themselves. AMFI and SEBI should focus on bringing in more players, and reduce the net worth and other requirements that restrict who can start a fund; more players means more competition, and as we’re seeing, more of the likes of HSBC and Motilal Oswal who offer zero exit load products.

To the investors, however, the concept of upfront commissions will not generate outrage. Because, today, it doesn’t hurt them. My father, what goes?

Subscribe to Capital Mind:

To subscribe to new posts by email, once a day, delivered to your Inbox:

Also, do check out Capital Mind Premium , where we provide high
quality analysis on macro, fixed income and stocks. Also see our
portfolio which has given stellar returns in our year, trade by trade
as we progress. Take a 30-day trial:

  • Bekxy says:

    Totally agree with your views Deepak. Today the big MFs can afford to pay out of pocket due to their profits build over the past few years. They have enough buffer. The smaller and loss making AMCs inspite of having better performing funds are the loser as they cant make the commissions by paying out of pocket. Many of them cant even launch new funds due to the new networth requirements!
    Hence introducing more competition, allowing small players to compete in a level playing field and letting performance pull in money rather than commissions is the thinking required

  • FB says:

    Partially disagree with you. The reason to regulate upfront commissions is that distributors are incentivised to push funds with higher upfront commissions disregarding the suitability of these funds to the investor. As commissions move from upfront to trail, the distributor gets paid only if the investor sticks with the fund, which would happen only if the fund performs to their expectation. Thus, it would align the interests of distributor and investor a little bit better than now.

  • Ayush Jain says:

    IMHO the MF industry needs more incentives to grow. I was looking at options for a relative, who is not tech-savvy and lives in a small town to make his first investment in an ELSS. It is not easy – first cross the KYC hurdle (which takes time), fund selection etc. I was not looking for direct plan, but not easy to find a distributor either. They have to now check if the local bank branches or CAMS/Karvy office will help out – not sure how helpful the latter is.
    Regulations like no entry load are needed to protect consumer interest, but at same time SEBI/AMFI need to look at how to grow the industry. With these kind of road-blocks, investor funds will continue to flow into FDs, real estate and Gold which are less of an hassle.