CLEANING UP OR CLEANING OUT

Cleaning up or cleaning out
December 15, 2009 05:54 PM
Sucheta Dalal & Debashis Basu
Source: Moneylife

SEBI has banned entry loads for mutual funds. The outcome has been catastrophic; more earnings for big banks and less service for retail investors. Analysis by Sucheta Dalal & Debashis Basu

Four months ago, the market regulator Securities and Exchange Board of India (SEBI) banned the entry load on mutual fund investment. SEBI’s intention was to save mutual fund investors an unnecessary expense and cut the clout of large distributors who were pocketing a hefty 6% fee for their ability to garner fresh funds. But so badly conceived has been SEBI’s action that it has ended up enhancing the clout of those very distributors who have exploited investors as well as asset management companies (AMCs). Amusingly, SEBI’s supplementary move to create an alternative—fund sales through stockbrokers—pushes the cost to the same levels as in the past and only creates a new business opportunity for brokers and depositories. Either way, all the plans and trial balloons floated, at the moment, indicate that the investor will either remain unserviced or go out of pocket. How did the regulator come to wield the broom with such a deadly unintended consequence? For the first time, here is the full story.

Over the past few years, there has been a lot of noise about how distributors mis-sold mutual funds (MFs) to investors, extracted fat commissions and also goodies such as foreign junkets, expensive gifts and entertainment from the asset management companies. Indeed, the big distributors got together with the fund industry and dumped on investors a lot of products that should never have been sold to them in the first place. Amazingly, even as they did so, most AMCs had no truck with their actual investors. Between funds and their investors stood three kinds of distributors—the big banks, other national distributors and smaller distributors, mainly the independent financial advisors (IFAs). The fund companies may be working for retail investors, as reflected in many emotion-charged ads, but these investors were really the customers of distributors, whose interests they easily compromised when selling a fund product with a large load. This ranged from dumping fancy new schemes at the height of the bull market, encouraging them to churn their MF portfolios and pushing schemes that fetched them the highest commissions, irrespective of their investment merits.
Earlier in 2009, SEBI, with many new executives in its ranks raring to make a mark, decided to do something about these dubious practices of the fund industry. Its big pro-investor move was to decree that mutual funds would not be allowed to charge an entry load.

Unfortunately, this is not turning out to be the big investor bonanza that it seemed at first blush. On the contrary, MF sales have collapsed and every alternative patchwork solution to mend the problem is turning out to be messy, difficult to implement or as expensive for the retail investor. To understand this, let’s look at the existing structure of distribution and selling practices.

Money-induced Mis-selling
Technically, the Association of Mutual Funds in India (AMFI) has certified a lakh of people who can sell mutual fund units; but only the top 20, mainly big banks such as Citibank, ABN Amro, HSBC, etc, account for 80% to 90% of the business, says an industry insider. They have a huge clout that nobody much knows about, least of all the regulator. The bonus and promotions of managers at these banks depend on the revenue they generate. Since new fund offerings (NFOs) provided the fattest incentives, distributors churned them to increase their own revenue. Usually, they “will not allow an investor to stay for more than two quarters in a fund. So typically, the investor makes 20% and those guys make 40% on the same portfolio,” says the CEO of an AMC. In addition, they arm-twisted AMCs to send them on fancy junkets or pay for promotional activities aimed at luring the customer.

One rung below are the national distributors, such as Karvy Consultants (with a nationwide network of 500-odd branches), and also Indian nationalised banks. They operated exactly like the foreign bankers; the only difference was that the absolute value of their demands was lower. “If I spent Rs2 lakh to keep a foreign bank happy, I’d spend Rs25,000 to meet the demands of a national distributor,” says our source. This was over and above the fat distributor commission.

Many of the big distributors have a sub-broker model, wherein they share a part of the front-end load and some of the trail commission (commissions that a distributor gets as long as the investor stays with the scheme) with smaller distributors. There are around 9,000 distributors who prefer the sub-broker model. These are usually the worker bees. They are the ones who are most likely to know the retail investor personally. Moreover, they rarely induce investors to churn portfolios unnecessarily and often even pass back a part of their front-end commission. Also, since they sell multiple investment products within their community, they are less likely to deliberately foist bad products on customers. It is this lot that has the maximum customer interface but the lowest ability to influence AMCs— who are worst hit by SEBI’s decision because they no longer know how to charge the customer.

The Consequences
The unintended consequences of SEBI’s action have ranged from the bizarre to the devastating. First, here is a shocker. Banks have smartly got around the SEBI rule by getting customers to consolidate portfolios and sign new agreements allowing them to debit customer accounts for each transaction and also charge an annual account maintenance fee. Effectively, they are still collecting at least 2.25% from customers. Meanwhile, AMCs under the ‘informal supervision’ of the regulator have agreed to pay 75 basis points as commission to the distributors. So bank distributors are collecting over 3% plus trail commissions and are unaffected by SEBI’s action. Meanwhile, the junkets and gratification are down, but older players like UTI Mutual Fund (UTIMF) still have plenty of money left over from exit loads accumulated over the years which they are using to great effect to grow their AUMs (assets under management).

Is there any evidence that retail investments have actually dropped? Or is this merely rhetoric to lobby for the restoration of loads? A source who refused to be named says that a good indicator would be to ask how many IFAs have not brought in fresh funds during the past three months. His information from the leading registrars (Karvy, CAMS and Templeton) is that it has dropped 70% and it is the small guys who have dropped off. IFAs have openly told fund managers that the economics of the new system just doesn’t work for them. It is exactly the same with the New Pension Scheme which finds no takers because there is no incentive to market it. Is this the scenario SEBI had in mind? There was clearly a need to rein in the big distributors, but not through a move that hits retail investors and retail distributors the hardest.

The fact is that the mutual funds business had not even spread properly all over the country when SEBI’s move has wiped out the last-mile contact. Even when mutual funds were charging fairly hefty entry loads, IFAs and retail distributors were scarce in smaller towns. “We find LIC agents but not mutual fund agents,” was an often-heard complaint even in smaller cities. SEBI’s action is not going to make it easier for them; instead “the big guys have become stronger and the small guys, who were actually servicing retail investors, have been decimated,” says one of our sources.

The Hidden Cost of Screen-based Model
Probably realising that by banning entry loads outright, it has thrown away the baby with the bathwater, SEBI has announced that stockbrokers will be allowed to sell mutual funds. Will SEBI’s proposal for a screen-based system of fund distribution work? While SEBI’s move was meant to serve investor interests, it looks more likely that investors may end up shelling out more than they bargained for. Our columnist R Balakrishnan, who was once the CEO of an AMC, points out: “Trading MF units through stock exchanges is akin to restoring entry load. The only difference is that the beneficiary changes from distributor to stockbroker. Investors would be better off paying a fee to a distributor and getting serviced.” Indeed, according to some calculations, the cost to an investor under the proposed route could reach up to eight times the expenses under the current model.

This is evident from the huge difference in transaction costs an investor would incur. Industry sources provided us the data for a comparison between the screen-based vs the distributor-based model to sell mutual funds. Under the present model, where investors approach distributors or apply to funds directly, only registrar and transfer agent (R&TA) costs are incurred by the investor. This boils down to per folio cost amounting to roughly Rs70 per annum. Whereas, under the depository/stock-trading model, costs will shoot up to between Rs540-Rs790 per folio per annum. In other words, the cost per folio would be eight times higher under the new model!

Data shows that an average fund investor invests Rs25,000 in any given fund. The entire fund industry comprises five crore folios for equity funds which, after de-duplication, would shrink to a mere 50 lakh-60 lakh investors. These are serviced at a cost of 16 basis points (this amount gives them facilities such as change of address, servicing, monthly account statement, change of bank mandate, etc). Only a fraction of fund investors have a depository account, says the CEO of an AMC. In contrast, the flat cost of a DP account is Rs350 and every change required by the investor (changing your mandate, etc) is separately charged on every transaction.

R&TAs are cost-effective when it comes to hosting large databases. While depositories today hold a mere 1.6 crore investor accounts, R&TAs hold 7.34 crore such accounts. Costs under the R&TA model are significantly lower as it plays a wider role. Industry experts indicate that brokers could charge between 0.25%-0.50% of the value of any buy & sell transaction involving MF units. However, it is not yet clear how additional costs, such as securities transaction tax and stamp duty, would be levied. Brokers may even charge separately for investors who want advisory or support services.

There are other issues as well. The penetration of mutual funds has been poor so far and brokers had little incentive to sell MF schemes. One leading national distributor points out that, although they have 400-odd offices, only 20 bring in big business. Clearly, 95% of their branches have no incentive to sell MFs right now. But they may develop an incentive for a perverse reason—only if they can induce investors to churn. In fact, the only attraction to sell MFs would be the 1% exit load and it would work for the distributor if investors are induced to churn their portfolio frequently. This would leave retail investors at the mercy of the brokers instead of the dubious practices of national distributors. Is this what SEBI wanted?
What Happens Now?
There were one lakh fund distributors, according to some back-of-the-envelope calculations by industry. It will be down to around 10 big distributors. Many large distributors are suggesting that sub-brokers pool in their sales with them. A sub-broker with Rs1-crore assets who earned 50 basis points converts it into the assets of the distributor who gets 75 basis points. Even if the distributor keeps only 10 basis points and passes the rest back, the sub-broker earns 65 points, which is much higher.

Some 20,000 bigger agents may remain as sub-brokers; the rest will find something else to do. That means a lot of jobs gone. This is the first consequence. A second unintended consequence is that with shrinkage in volumes, the registrars will reduce employee headcount. And finally, we don’t know whether investors would pay for the ‘advice’ and whether fund distributors can actually charge them. Indeed, it may well be that piqued distributors will take to selling unit-linked insurance plans vigorously, in place of mutual funds, which would really be terrible for investors.

SEBI blithely decreed that distributors would have to charge for the advice they give to MF investors but this is all theory. Hemant Rustagi of Wealthwise, a top IFA, is not sure of how and what he is going to charge. “The structure will take time to evolve. We definitely intend to charge. It depends on a lot of factors—how long the customer has been with us; the size of his portfolio; whether he is a regular investor. Unfortunately, it is not something where you can easily put down the number. The problem with most investors, especially retail and mid-size investors, is that they are not in a position to tell you how much they would be investing in a year. If that is not possible, we can’t have a fixed rate. It is purely based on what relations you have with the client. We are in the process of working it out.”

Mr Rustagi hopes that “investors would look back and see what we have done for them. If he feels that we have done justice to the best of our ability, we kept investor’s interest foremost, we are aware of what we are talking about, we have been with the investor through good and bad times and kept them up-to-date, charging is not a problem.” But, at the same time, he says, “Ultimately, it boils down to how many new clients we can get. Would that be impacted? Yes, it would. The clients realise that costs are involved, and if you don’t want a drop in the level of advice, somebody has to pay. Our growth would be affected, as one needs resources, money and manpower to reach out to more and more people.”

What can be done now to reduce the blow? SEBI can easily address the issue of distributor fees by forcing AMCs to adopt a transparent pricing system where the load or commission is spelt out upfront and all other payments to distributors are disallowed. But for such course corrections, SEBI has to talk to national distributors and the IFAs and the MF industry has to speak up through AMFI. Currently, AMFI is doing a lousy job of putting the industry’s views across (See Box: “Fund Industry Needs Better Lobbying”). That is one reason why, when SEBI wielded the broom to clean up the fund industry, it did not look around to see who was getting hit. (With inputs from Sanket Dhanorkar)


Finger-pointing
Did the foreign funds influence SEBI’s decision, which mainly benefits the banks?

Frustrated investors as well as IFAs are now wondering whose incessant complaints led to the SEBI action of banning entry loads. The finger points to some foreign funds, who run high overheads, have a low retail reach and needed a solution to match the continuous expansion of the larger Indian funds with their retail distribution model. According to an insider, funds with a relatively large retail base such as UTI, HDFC or Reliance, have hundreds of branches and were working with 9,000 to 10,000 IFAs who got in a big chunk of their business. This model made these AMCs profitable, because the IFAs are paid at least 1% less than the large distributors. Some funds paid them just 1.75% from the entry load and they retained the rest as marketing expenses. Even the trail commission paid to IFAs was 50 basis points. This was half of what was paid to banks and national distributors. Indeed, foreign banks simply do not sell the products of many large Indian AMCs which went about building the retail network and sold their units through IFAs. Even after the entry load has been abolished, these AMCs continue to sell new schemes through the IFAs alone.

It was the smaller foreign funds that were completely tied up with banks, especially foreign banks. But these AMCs run a high-cost structure which made it impossible for them to go retail. They were struggling to be profitable because of high expenses of selling; the money essentially going into the pockets of the foreign banks. These funds will remain hobbled by high costs, whether or not SEBI permits entry loads. A source tells us that the biggest cost of these funds is their own wage bill and establishment costs. Marketing is only a fifth of their costs.

For instance, points out an industry source, Sundaram Mutual Fund, with 50 branches, excellent products, a good image and many distributors, had a wage bill of Rs19 crore while Fidelity with 11 branches had a wage bill of Rs32 crore. Foreign funds have a structure that makes them beholden to large foreign banks for MF sales and they remain susceptible to their pressure. SEBI’s move has helped them by practically favouring the banks and hurting the smaller distributors, mainly the IFAs.

Exchanges Are Planning MF Trading Platforms
Both BSE and NSE are planning trading platforms for mutual funds. AMFI is planning to buy 30% stake in each of them, unmindful of a possible conflict of interest

While distributors are still trying to come to terms with the new regulations banning entry load in mutual fund schemes, fund houses are feeling the heat, as distributors have lost the incentive to push their products. This has meant a 60%-70% drop in mobilisation by mutual funds. Amidst all this, one of the options being considered for selling mutual funds is to have independent trading platforms for mutual funds, led by the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). This follows the permission given by SEBI to sell funds via the stockbroker-demat route, like stocks. According to sources within the industry, the first one would be set up by the NSE and National Securities Depository Ltd (NSDL) while the second one may be set up by the BSE and two R&TAs, CAMS and Karvy.
Interestingly, AMFI, which represents the interests of the Indian mutual fund industry, is planning to take a 30% stake in both the trading platforms. However, some members of AMFI have raised a valid concern about this proposed move, pointing to a potential conflict of interest in taking large stakes in two rival platforms, especially since some of the leading fund houses, like Templeton, are planning to introduce their own platforms rivalling those of the BSE and the NSE. Again, these are prominent members of AMFI and a stake in the BSE and NSE platforms would lead to another area of conflict of interest. “Also, if there are investor grievances with regard to a particular fund, what would be the spill-over effect on the whole platform? Wouldn’t other members get dragged into the issue as members of the AMFI-promoted platform?” asked the CEO of a large AMC, requesting anonymity.
When some members raised these issues at a meeting last week, it was apparent from AMFI’s half-hearted answers that the proposed move hadn’t been thought through in detail. Also, AMFI had apparently assumed that it would have access to the entire database of R&TAs as a promoter of this platform. But this assumption seems too naïve. “While the AMFI office-bearers are now rethinking the entire issue, the whole idea looks like a non-starter,” according to the CEO of another top AMC.


Fund Industry Needs Better Lobbying
Does the fund lobby AMFI have an effective voice or does the regulator simply ignore it?
R Balakrishnan asks

Is the Securities and Exchange Board of India (SEBI) working for the insurance industry overtime, at the cost of the mutual fund industry? Recent moves to totally abolish exit load or the quixotic move to let mutual fund units be traded through a stock exchange would maim the fund industry and help insurance companies which compete with equity funds with unit-linked insurance plans (ULIPs), their top-selling product by far. What about the response of the fund industry to this? There is something called the Association of Mutual Funds in India (AMFI) which is the industry lobby. The regulator is clearly ignoring AMFI which seems to have been caught with its pants down. The same AMFI, which used to be entrusted by the regulator to frame guidelines (which virtually became law), now looks like a toothless tiger!

Unfortunately, AMFI has always functioned as a private club run by a handful of large mutual funds which have (ab)used the platform to consolidate their market position and also create entry barriers for the later entrants. I can say this as I was part of the industry for some time and, now that I am out of it, a few mutual fund CEOs mention this. They are upset with AMFI (too late, I think; SEBI is already on its own path which brooks no consensus) after having tolerated it for so many years. Some CEOs care a damn about AMFI and, interestingly, some actually want to walk out of it. In fact, I remember having asked someone in SEBI (when I was as frustrated with AMFI as others are getting today) if I need to be a member of AMFI, since it is only a voluntary trade body. The SEBI official said I could stay out, but it could create some unpleasantness in an emerging industry.

However, I was determined to make one attempt to do something. A number of smaller mutual funds (some of them have gone on to become big), in fact, petitioned the chairman of AMFI to call for a meeting and seek clarity on how the board of AMFI is constituted (the board is a crony club, with some large mutual funds hogging the positions. In fact, large funds, like UTI, used to send middle-level executives to the board rather than the CEO, unlike other mutual funds). I recall that over a dozen mutual fund CEOs had signed this petition and there was some discussion on the issue, but nothing came of it. At some point, SEBI (in its ignorance?) wanted AMFI to become a ‘self-regulatory organisation’ or SRO. While the AMFI chairman did not (could not?) oppose this publicly for fear of personally antagonising the SEBI chief, the move died a natural death after a lot of noise in the media. The members were aware and almost unanimous about not wanting AMFI to become an SRO.

As a past participant, I clearly recall a couple of issues where the large fund houses rode roughshod over the others by using the AMFI platform. These include the rule about banning ‘rebating’ or the so-called ‘20/25 rule’ relating to the number of investors in a fund. The larger ones had come up using these ladders; and, once they climbed a few steps, they kicked the ladder away so that others could not climb. I recall fighting these two issues, but was shouted down by the ‘elders’. In most instances, the crony club takes the decisions and most members learn of changes being brought about, even by AMFI, through the media!

AMFI has to change, if the fund industry has to make its voice heard. It needs better representation and a more transparent process of board composition. Funds, like UTI or Templeton, have been on the board of AMFI as if it is their birthright! The ostensible argument is that the board should comprise people from fund houses with the ‘largest’ AUM (assets under management) because it becomes ‘more’ representative of the industry. AMFI has had just one full-time chairman who has been there since inception. From talking to people in the industry, and from my personal stint there, I think the following changes should be brought about in AMFI:
i) At least one-third of the board should compulsorily retire every year;
ii) No fund house should be on the AMFI board for more than two consecutive terms;
iii) Hire experts (on the board) who know the subject and who can carry weight with the regulator;
iv) AMFI is overly dependent on the present chairman who has been on the board since inception. This issue needs to be addressed;
v) Create a governing board, ideally through a secret ballot. Here, the fund CEOs have to take interest in active participation in AMFI.

Investors couldn’t care less about AMFI which is a trade body. But, had AMFI played its role properly, the current issues would have been handled with more care and caution.

R Balakrishnan (The author was the CEO of First India Mutual Fund and later its acquirer, Sahara Mutual Fund)