Turmoil continues in the mutual fund industry concerning how funds are sold. Despite SEBI having radically upended fund companies’ and fund distributors’ business model over the last five years, there still seems room for further R&D. Part of it arises from unintended--but entirely predictable--side effects of regulatory changes. Obviously, caught in the middle is the investor, who is still being sold products that might make business sense for the sellers, but are not the best investment option.
To understand what is happening, let’s examine the changes that have taken place. Fund distributors--who range from individuals working from homes to large organisations like banks--get paid in two ways when they get an investment. One, a percentage of the investment right in the beginning, and two, a continuous monthly commission that is a percentage of the assets, which continues for the lifetime of the investment. The former is called the upfront commission and the latter trail commission.
Generally, there is a tradeoff between the two. If the product is such that the investor is locked in for a certain time, then the upfront commission is high, and there is no trail commission. This is true for closed-end funds, where the investor is locked in for three or five or even longer periods. Asset management companies’ revenue stream from these funds is guaranteed for that period so they can afford to pay a high commission out of their own pocket, secure in the knowledge that the revenues will come. And of course, higher commission means higher sales, of which there is never any doubt for any financial product. And the high commissions really are quite high--it seems that up to 5 or 6 per cent may be paid to large distributors who can get money in bulk. Even small distributors get 4 per cent.
There is a huge shift to closed-end funds that is driven by this. In the last one year, more than half of the fresh money that has flowed into equity funds has come into closed-end funds. In the decade before that, the equivalent number was less than ten per cent. Unfortunately, closed-end funds have significant disadvantages for investors. The money is illiquid, which means that you can’t use it in time of need, nor can you shift to another fund if the current one starts underperforming.
Now, this new model seems to be getting the close scrutiny it deserves. In an interview that I took for Mutual Fund Insight, SEBI Chief UK Sinha said that the regulator was uncomfortable with the level of commission that was being paid, although it had not yet made up its mind on whether any action should be taken. On another front, it seems that smaller AMCs within the industry are also increasingly uncomfortable with this trend. As I’ve described above, this business model involves an AMC spending the first two years or so’s revenue (5 to 6 per cent) in order to get the money in. That means to get a meaningful 1000 crore rupees of equity assets, one has to spend at least Rs 50 crore up front, earn it back for two years and only then start making money.
This is a method of buying assets by paying in advance that is unaffordable for the smaller AMCs. Also, as we’ve seen, it can only be practiced with a type of fund that is less than optimum for investors. And yet, this is the growth segment of the mutual fund industry today. Basically what we have here is yet another market distortion that has come about because the investor’s, the AMCs’ and the distributor's interests are not aligned. The only way to align them is to switch to what has been obvious for a long time--an ‘all trail’ model of commissions. In this model, the distributor gets a fixed amount (not a percentage) for executing the transaction and after that, get a percentage of the amount invested, as long as it stays invested. If the investment grows, his commission grows, and vice versa.
That’s the only logical solution for all these misalignments that mutual funds suffer from--the question is whether it will ever happen.
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