The Association of Mutual Funds of India's (Amfi) new guidelines seeking to cap the upfront commission that mutual funds can pay distributors at 1 per cent are unquestionably well-intended. But whether they will prove effective is open to question.
There is no doubt that high upfront commissions (going up to 6-7 per cent of the funds collected) have given rise to many undesirable practices in the mutual fund industry. Though fund houses may deny it, high upfront incentives have led to quite a bit of mis-selling in this bull market, with thematic and micro-cap funds being aggressively peddled to risk-averse investors.
It is also thanks to upfront commissions that over 70 per cent of the new money flowing into equity funds in the last one year has gone into closed-ended funds. Many first-time equity investors have been unwisely steered into closed-ended NFOs, when they would have been better off with older diversified funds with a proven track record.
Past experience with mutual funds as well as other financial products shows that high upfront incentives (with no trail fee) encourage distributors to adopt a 'sell-it-and-forget-it' approach. Just look at the sheer number of investors who are stuck with ULIPs or traditional insurance plans, with no idea why they bought them. If the insurance industry is today grappling with extraordinarily high rates of lapsed policies and orphaned policyholders, it is the 35-40 per cent upfront commission structure that is clearly to blame.
Front-loading of incentives also leads to needless portfolio churn, which can be very counterproductive in market-linked products. Instead of encouraging investors to hold on to them for the long term, advisors are incentivised to keep promoting new products to the same investor.
All this suggests that it would be good if all mutual funds opted for a balanced model of distributor incentives, where the advisor earns equal portions of his fee from upfront commissions and trail fees. The upfront payment would take care of his immediate cash flow needs and the trail fee would ensure that he makes part of his return only when the investor does.
But it is clear from the events of the last one year, that some fund houses would like to prioritise AUM over investor interests time and again. Similarly, some investors seem to be drawn to NFOs like bees to honey, even when they receive plenty of advice against it.
This suggests that both sets of participants are unlikely to change their behaviour much, no matter what further safeguards are put in place by regulators.
It is not that Sebi's existing regulatory structure to protect mutual fund investors from mis-selling or poorly designed products is weak. In fact, Sebi's current rules on commission structures and marketing practices for mutual funds are already the strictest among financial products.
For one, upfront commissions paid to MF agents out of the investor's pocket have been completely banned for the last six years. In contrast, insurance plans continue to pay upfront commissions of 35-40 per cent from the investor's first year premiums. Debt instruments, ranging from corporate fixed deposits to post office schemes, though they call for little 'advice', pay upfront commissions of 0.5 to 3 per cent to the agent too.
Two, to prevent funds from overcharging their customers, the Sebi has also capped the total expense ratio for mutual funds. Therefore, no matter how much a fund splurges on upfront incentives and then tries to recover it in later years, the annual expenses charged to investors cannot exceed the statutory limit of 2.5-2.75 per cent. Other financial products, except ULIPs, are not obliged to stick to any such expense limits. Indeed, the fungibility on MF expenses introduced two years ago ensures that a fund house which increases its distributor incentives inordinately does so at the expense of its own profitability.
Three, the Sebi also actively discourages frivolous product launches by asking a fund's trustees to certify, at the time of every NFO, that the new scheme is not a clone of older ones. There are also fairly water-tight rules governing what a mutual fund may promise investors (no assured returns), how it may advertise its performance, how it can name its schemes and so on.
Hobbling the good
Put together, these regulations are good enough to afford fairly strong protection to mutual fund investors from the malpractices that characterise most financial products and services.
This is why, having done all this, it amounts to micro-management for the Sebi or Amfi to now tell individual fund houses how they should spend their overall expense limits or structure their commissions, even if paid out of their own profits.
Both the Sebi and the Amfi should note that tightening the commission rules for MFs any further, while other financial products go scot-free, would hobble those players in the MF industry who do put investor interests first and are meticulous about following the rules in letter and in spirit.
As for fund houses which continue to pay high upfront commissions, it is clear that they have managed to find loopholes around all of Sebi's earlier regulations.
So how difficult will it be for them to circumvent Amfi's new 'guidelines'?
An upfront monetary incentive, if capped, can always be replaced by expensive gifts in kind to distributors, unofficial pass-backs or even trips to New Zealand or Thailand, all paid out of the AMC's pocket.
But what about the investors who are misled into buying wrong funds? Are they to be left in the lurch? Well, there can be two possible outcomes for them as a consequence of their headlong rush into closed-ended funds.
One, the funds may, as promised, deliver splendid returns over the next three years and leave these investors convinced of the benefits of equity investing. In that case, when these closed-ended funds mature, the fund houses in question would have acquired a new set of long-term customers for their equity products.
Alternatively, these NFOs could well deliver abysmal returns over the next three years, due to either poor stock selection or an unexpected market meltdown. This will leave their investors with a poor return experience. In that case, the disillusioned investors may either jump to open-ended funds (if they fared better) or go back to the safe harbour of fixed deposits. In this case, it is the select fund houses which are pursuing the aggressive path of high upfront incentives who will be the sufferers.
Fund houses which have stayed the course during this bull market, giving in neither to the NFO rush nor to upfront commission demands, would not only have the benefit of more mature investors in their schemes. They would also have market-cycle-proofed their equity business. Good luck to them!