In a major overhaul of the fee structure that mutual funds charge from investors, markets regulator Sebi Tuesday decided to cap the total expenses for investment in such funds to 2.25 percent.
Sebi, in its board meeting, announced changes in the total expense ratio (TER) of mutual funds. The changes may bring in transparency in the appropriation of expenses, and reducing mis-selling and churning.
Aashish Somaiyaa, CEO of Motilal Oswal AMC, Feroze Azeez, deputy CEO at Anand Rathi Financial Services, Nimish Shah of SBI Wealth Management, A Balasubramanian, CEO of Aditya Birla Sun Life AMC discusses the new proposal.
The reduction in expense ratio has been on for a while, but a simultaneous change in the manner of payout of commissions. Your initial thoughts on what was announced last week?
Somaiyaa: The outset is fabulous for investors because by various estimates one can imagine that anywhere between 20-30 basis points or at least 15-30 basis points kinds of savings for equity funds would be passed on to investors, so no doubt about that at all.
As far as the working of the industry is concerned, in terms of selling patterns, in terms of how do we make our funds available to end investors and how highly regulated, the well-established product continues to penetrate on that front. We will need to realign quite a few things and we might face some challenges. First up I can say it is fantastic for investors because straight away it adds to their returns.
Your initial thoughts and I know it is early days but how exactly do you think will these regulations be rolled out? How will this whole Trail Commission model really work?
Balasubramanian: There is absolutely no doubt as it exists in any other industries, it benefits the investors. In our case, the mutual fund investor will benefit out of the proposed reduction in the expenses. Also one has to remember the fact that India is still under-penetrated in terms of expansion getting more and more customer base. Therefore, the hard work which both mutual fund players and the distribution community have to undertake in order to build the size has to remain the same.
At the same time, the cost factor for each of us has to be re-looked at given the fact that it is going to have a revenue impact both for the AMC as well as for the distributors. Therefore, to look at the business model is to actually look at where all the cost structure can be cut, where all the automation can help us in building the cost structure come down, at the same time optimise my revenue.
Drop in the upfront commission there is no doubt that it impacts the sales for the first year. At the same time, the trail commission which comes over a period of time as the market keeps going up and as the portfolio value keeps rising one should remember the fact that the commission also increases the revenue potential for both the AMCs as well as the distributors.
Therefore, one has to re-look at the whole business model in terms of how each one of us has to adjust given the fact that the decisions will be coming in soon from the point of view of implementation.
In the 25 years of mutual fund industry, every 5-6 years the business model keeps undergoing a change. One has to, of course, keep adjusting the emerging trend through the regulations as well as many other aspects.
Help us understand, we will come to expense ratios in a bit, but first, as an investor, I need to understand how the commission model is going to work? So just explain your understanding of trail, at what point will the commissions be paid and what an investor needs to be aware of?
Somaiyaa: In the past, the commission used to be paid in two formats and it could have two components basically. One component was that when the investment is made at the end of the same month a certain part of the fraction of the investment had to pay as commission which is called upfront. Because it is on an immediate basis.
The second element which is called the trail commission means that it is paid through the life of the asset. So as long as your investment is in force with the asset manager, throughout the period a certain fraction is paid.
Typically is that on half yearly basis, annual basis how frequently are the incentives paid out?
Somaiyaa: It is paid every month. I will give you an example, if the trail commission let us say is 0.6 percent, 60 basis points so it is 0.6 percent annual which means it is 0.05 percent per month. So, the mechanism of payment is that for the month the average assets are calculated and then multiplied by 0.05 percent which would annual out to 0.6 percent. So, it is basically calculated for annual average assets settled every month in fractions. So, that is trail commission.
The other one upfront means obviously the month where it is invested immediately something. Now somewhere there is this belief that instant gratification is what appeals to human beings. So there is a belief that if you pay upfront commission and the higher the upfront commission it is feared that might act as an influencer for where the investment could be directed.
Because if X pays more upfront and Y pays less upfront or no upfront, then it is perceived that X is a more attractive proposition from the intermediaries.
Q: From the distributors' point of view.
Somaiyaa: I am telling a perception. So, now the move is that you kill that whole fear and say that okay no upfronts can be paid. So for the intermediary, there is no instant gratification. In some sense, one can also say that there is an alignment of interest for the asset manager for the intermediary and for the investor.
Because if the asset manager performs and provides a good service that is when everybody wants to stay invested. But if you pay upfront commission then the investor is in the fund the asset manager yet has to perform but the intermediary got his share of earning right at the start itself.
Therefore, the propensity or what is always said the propensity to lead investors to churn more because the more cheques people are writing, the more commission you are earning.
Somaiyaa: It can be. Within intermediaries, there can be very good quality intermediaries and on the margins, there could be some who are influenced by these practices.
To remove any such doubt, what has been done is that now as an asset manager you just can't pay any upfront, all commissions have to be necessarily trailed, which mean that it is aligned, till the time I perform, the investor stays and the investor is being serviced and only till then the commission is paid.
These are seminal changes. How do you think they are going to be taken by the distributor community?
Azeez: It is a very good move. To quantify what that is, if you are looking at equity, it is a 10-year investment. If it is a 10-year investment there are three reductions it. One is, of course, the TER, the second is the B30 commission which was an average of 17 paise, that is 0.17 percent and it should ideally come down to 3-4 paise.
B30 is the expenses that a mutual fund could charge for going forward and penetrating into smaller cities and towns, right?
Azeez: Yes. The fund was allowed to charge an expense. So, that was almost about 17 paise, that comes down to 4 paise. So, there is a straight reduction in TER, there is a reduction here of 13 or 15 paise, then the GST on a portion of it also reduces because if you are charging less then there is a lesser GST being charged.
There is an absolute impact of 40-45 paise in certain schemes envisaged. This looks very tiny but the attractiveness of this is enormous. For example, if I have Rs 10 lakh investment for 10 years, now I am going to get Rs 1.62 to Rs 1.7 lakh more in a 10 year period. So, this is a gift of almost a one year return to the investor. So, you have to quantify that, it is a very large quantum.
Second, there is a lot of malpractice which was going on. Mutual fund being the most regulated platform for a person to participate in good assets, there was still a lot of malpractice which was happening, I think that is going to be curbed dramatically with the upfront going away.
Any distributor who has the long-term business model in mind would not actually be perturbed, for example, Anand Rathi decided to go all trail three years back and I think it will be a cleaner business.
Third point is, when you are doing stuff like this what will happen is that penetration is going to become far simpler. However, one word of caution is in times like these advisors starts giving advice on other platforms like AIFs and PMS which actually motivate them on a larger upfront commission.
Ideally, Sebi should bring all the products which can be infused in a portfolio on the same platform, otherwise like a PMS assets have become 10 times in the last five years.
How much higher are commissions typically paid out for PMS schemes because for large ticket investors, I am guessing that might the advice coming in that instead of mutual funds, why don't you experiment with a PMS?
Azeez: Their upfront commissions are not regulated. So, I have been offered as wealth management advisor a 4-5 percent commission upfront. Of course, that gets normalised over a period but that is the kind of commission which is not an abnormal commission. So, that is very largely motivating for a person to change his business model which I think should be restricted.
Your thoughts on the manner in which this will roll out?
Shah: If you divide the issue into two things, one is in terms of capping the TER and second is in terms of the upfront commission. So, if you look at the TERs, definitely pro-investor move by Sebi. As far as an upfront commission is concerned, I think it will bring in a level playing field amongst all distributors.
Till now, it all depended on how your business model is, for example at SBI when we started in January 2016, a decision was taken that we are going to have 100 percent trail commission model, a lot of the platforms are already shifting to 100 percent trail commission model in anticipation of what the investors want.
I don't think there is much of an issue as far as upfront versus trail commission is concerned because that is again pro investor. So, we feel that this is definitely going to be proactive but the cost of acquiring a client is now suddenly increasing and it will definitely hit the smaller distributors more than the larger ones.
Your word on this issue before we move on to expense ratios, just how you see the entire industry transitioning to the trail model where there is practically nothing paid up front?
Balasubramanian: The way it works is from the time the sales are made then the expenses start ticking in. The mutual fund managers will be allowed to charge expenses from the time money comes on board on the basis of the average assets each scheme have got and the moment the expenses hit the books of accounts then it has got two components.
One is, of course, the management fees and second is distribution selling commission which keeps accruing it and both the AMC fees and distribution commission will be accrued. At the end of the month whatever is accrued is taken to the AMC books of accounts. That will come in the form of management fees and rest of it from the scheme itself will go to distributors in the form of trail commission.
The way I think the model works is the trail commission is generally paid out around 10th and 12th of every month and that model I think nothing will change, it will continue except there will be a reduction in terms of the payout linking directly to the reduction in the expenses.
Already people are wondering because the way the slabs work is, the smaller the size of the fund, the greater the expense ratio it can charge so the greater it can incentivise the distribution channels, is there going to be a propensity, therefore, now to sell a more of this smaller funds because that again is a bit of a risk for the end investor?
Somaiyaa: I think that can be a minor influence because there can be a difference of 0.2 percent, 0.25 percent or some such number and all said and done, people may not want to severely compromise on the performance delivered because all said and done, intermediaries ultimately are answerable to investors.
If you, just for the sake of a few basis points because now upfront is clearly out of the window, so you have only to choose from a higher trail or slightly lower trial or some such thing and the gap will be 0.2 or 0.25 or something like that.
So I think the ability for commissions to influence sales is definitely going to go down. The regulation is going to, if the objective was to reduce the influence of commissions, meet the objective. There will always be some or the other outlier but the incentive to do what you are alluding to is very less.
Same question to close-ended funds because again for closed-ended funds, it has been clearly capped at 1.2 percent for equity funds. So what happens to this category of products?
Shah: If you look at on the equity side, not many close-ended funds were being positioned, it was more from the point of view of having a balanced advantage fund or more of a debt-equity combination as such.
So yes, there will be an impact as far as the net sales are concerned because those schemes were largely required to be positioned more as FD plus kind of return.
To that extent, there will be a reduction in earnings on that particular – but if there is investor requirement for that kind of a product, I don’t think the sales will slowdown.
Your thoughts on expense ratios, do you expect any sort of change in the advisory channel and the distribution channel purely because of the cut in ratios, the TERs?
Azeez: I think a paradigm shift in how mutual funds are going to be advised because the banking channel, which is 30-40 percent of the total mobilisation was getting significant portions of upfront. If I have to be very transparent and that would be as high as trails being paid upfront, 2-3 percent.
Now if you have one percent trail on one side and 3 percent upfront on another, that gap is large enough to influence and that will go away. So, banking channel to my mind will start focusing on ULIPs.
Private banking segment, which was or the other national distributors as we call them, who were focusing on mutual funds would start focusing on alternate products to get their commission. So, advise delivery will be far cleaner point one.
Practices like upfronts will change the way people will look at long-term assets. Thirdly, I think asset management company business will be lesser cluttered because there is a huge entry barrier now for a small player to come. Today, you have 42 asset management companies, 10 MNCs have quit this business in the last ten years.
I think, further consolidation is inevitable and that is good for an investor because you don’t need 42 managers at least asset management companies. We have 145 equity mutual fund managers, we have 500 open-ended schemes, of course, these schemes might not compress but the confusion is going to be lesser.
If you have to take your 1.5 percent penetration of the country’s population to whatever globally it is 30-50 percent, you will need lesser clutter. I think that will serve the purpose. Coupled with good investor education because if this is the rate at which investor education continues, Rs 10,000 crore is going to be spent at least in the next 10 years and that is a lot of money.
Your thoughts, I don’t know if you agree with that, will this be the kind of trigger that also sort of brings in consolidation and also a word on SIPs because I remember reading the Sebi circular, which clearly says that with respect of commission, there is a carve-out for SIPs, there you as the CEO of the mutual fund can still pay some amount of upfront commission, how will SIPs be sold because that is the vehicle of choice for a large section of retail?
Somaiyaa: One hundred percent I agree with what Feroz Azeez mentioned about decluttering.
On a lighter note, somebody was telling me that there are some 150 good stocks to buy and some 500 funds available in order for you to buy those 150 stocks in the market. Decluttering is very important and I also agree that if you want penetration to increase, you should give fewer and crisper kind of choices rather than confusing people. I think close-ended funds are out. So that is a good thing at least from what I understand.
I have a slightly different view on consolidation of SIPs because I feel that there will be more and more players who would come in, the reason being that you take the US experience.
In the US for example, there is PMS, AIF, mutual funds and typically what happens is that for every hundred dollars worth of investment in a mutual fund, in the US, you have nearly $50 worth in alternates and that is because these asset classes provide you – while it is true that they have more leniency in terms of how they can be priced at but they give you the ability to innovate, take more aggressive positions, come out with different risk-return combinations, for example, long-short funds you cannot do in a mutual fund, 10-12-15 stocks buy and hold, aggressive portfolio you cannot do in a mutual fund, so many of these things.
Coming to SIPs, I think that there is a belief that SIP is the right way to invest. So in order to incentivise right practices, the regulator has said that for SIPs, it is anticipated that for three years’ worth of commission, you can upfront, so basically what it means is that if you are doing a Rs 2,000 SIP, it is Rs 24,000 per year and Rs 72,000 in three years. So for that Rs 72,000, some commission can be paid upfront.
Some, not all but some?
Somaiyaa: Yes, some part of it, not the whole TER or something like that, there will be some commission.
The big question also from an equity market point of view is that the equity market anyway has its own issues and now the fact that the entire mutual fund distribution model is going to undergo a change – how long will the transition take and again does this mean a drop in mutual fund inflows at least in the immediate term?
Balasubramanian: The funds are being sold on the base of various parameters. One is the fund house acceptance both for the distributors as well as for the investors. Second is the product suitability and third is what is the period for which is coming and then final is the expenses.
There some amount of selling will happen on the basis of how much you are getting rewarded and how much of the expense you are charging. At the end of the day, one cannot move away from the fact that the selection methodology remains constant irrespective of whatever the expenses are there. Therefore to some extent, the same policy will continue. At the same time, there are many fund houses even on the smaller size and nature.
Q: What I am trying to understand is that – we have discussed the fallout of the expense ratio cuts but on the market as a whole, with respect to the way in which flows have anyway been coming down, are you expecting a bigger drop in the near future?
Balasubramanian: Currently, the decision of the board is out in the public domain. One has to wait for the detailed note to come from Sebi clearly giving the time of implementation.
Of course, the system also needs to get adjusted, therefore, they will give some kind of time for the industry to get adjusted. This sufficient time will be given for implementation of this.
As far as the inflows are concerned, it is linked to the market sentiment – as in the month of August, we have seen some bit of a reduction in the flows in the equity mutual fund schemes and even September also remains more or less the same.
Ultimately, the flows into the equity mutual funds both in fixed income equity would depend upon the conviction of participants in the capital market through the mutual funds and given the fact that investments are made for long-term, the same time the market volatility would also drive the flows and also the recommendation both from the AMCs as well as from the distributions as well as from the investors mind-set.