Do Fund Companies Dislike Direct Plans?

Recently, I had a rather curious interaction with a fund company. Promoted by a public sector bank, the fund company ranks among the larger ones in the industry.

I invested in an equity fund opting for Direct Plan; as per norm, the payee on the cheque was: XXXX Fund – Direct Plan – Growth; the same was explicitly mentioned on the transaction slip as well. Oddly, the statement of account revealed that I had been allotted units under the Regular Plan.

Assuming that it was a clerical error, I wrote an email to the fund company explaining the facts of the case. To my surprise, they wrote back saying “With regards to your query, we would like to inform you that a broker code (ARN Code) was mentioned in the application submitted by you, hence we allotted the units in regular plan. We request you to kindly contact with the respective branch for further assistance.”

I haven’t engaged a distributor for several years now. Furthermore, even if that were the case, the fund’s Scheme Information Document (SID) states that in cases where a broker’s code is mentioned and the plan mentioned is ‘Direct’, the default plan is deemed to be ‘Direct’.

In effect, the fund company had violated its stated guidelines.

After a significant back and forth over email and several tele-conversations, the fund company grudgingly agreed to modify the plan from ‘Regular’ to ‘Direct’.

This episode got me thinking about why my investment had been earmarked under the Regular Plan instead of the Direct Plan. As was evident from the email, it wasn’t an oversight. Rather, the fund company staff was following laid down procedure. Simply put, they had been instructed to act in a manner that was in contradiction to what the SID stated.

But why would a fund company indulge in such skulduggery?

It is common knowledge that despite Direct Plans having been in existence for nearly four years now, a bulk of mutual fund assets continue to be garnered by distributors under Regular Plans.

Moreover, Direct Plans have a lower expense ratio as compared to Regular Plans since distribution expenses et al are excluded. Also, no commission is paid to distributors under the Direct Plan.

In other words, assets under Direct Plans can’t be utilised to compensate distributors. Sadly for some fund companies, that’s unacceptable because in their books, distributors are more important than investors.

Don’t get me wrong. I’m not making this out to be a 'distributor versus investor' debate. However, the fund company has done so, by creating a mechanism to surreptitiously transfer investments from Direct Plans to Regular Plans.

Distributors have an unquestionable role to play in the mutual fund industry. Fund companies are entitled to utilise their services and compensate them as deemed fit. However in their zest to provide for distributors, investors’ interests shouldn’t be compromised.

Investors on their part must evaluate a fund company’s pedigree while making investment decisions. Fund companies that fail to watch out for investors should be steered clear of.

Direct Plans: Much Ado About Nothing

Admittedly, when I first heard someone complain about direct plans, I was surprised. But over time, the negative buzz has only grown. A few months ago, I met some individuals who are engaged in mutual fund distribution. Their grouse was that introduction of direct plans has resulted in a significant loss of business for smaller distributors like them. They were convinced that it was only a matter of time before all mutual fund investors migrated from regular plans (wherein the expense ratio includes distribution expenses, commission et al) to direct plans.

Then there were investors who were unhappy with their investments in direct plans. They maintained that direct plans were responsible for their woes. Things came to a head last month when SEBI issued a circular mandating that fund houses disclose information regarding commission paid to distributors, among others. Some concluded that this was a sly move to promote direct plans at the cost of regular plans.

In all the aforementioned cases, direct plans were painted as villains of the piece. But do those arguments hold weight?

       

Let’s consider the first grouse: direct plans have resulted in small distributors substantially losing their business. As per data released by AMFI, as of Feb 2016, “39% of the assets of the mutual fund industry came directly. A large portion of direct investments were in non-equity oriented schemes where institutional investors dominate”.

It is common knowledge that most institutional investors were (and continue to be) serviced by large distributors i.e. distribution arms of banks, broking firms and distributors with a nationwide presence. So it can be safely stated that institutional monies flowing from distributor mode to direct mode hasn’t had a significant impact on small distributors.

Now let’s focus on retail investments i.e. the universe largely catered to by small distributors. AMFI data reveals that of the total industry assets (INR 13.5 trillion), roughly 44% were held by individual investors; of these just 13% were invested in direct plans.

It is noteworthy that direct plans with a lower expense ratio have been on offer since Jan 2013. In other words, even after more than 36 months, a bulk (87%) of retail assets continue to be invested via distributors. The much-feared and speculated exodus of retail assets from distributor to direct mode hasn’t taken place.

The second grouse—investors expressing dissatisfaction with direct investments—has its roots in a half-baked understanding of how direct plans should be utilised. After they were introduced, benefits of direct plans (lower cost versus regular plans, and thereby higher performance potential) were universally extolled. Expectedly, some investors decided to invest independently, and chose direct plans over regular plans. However while doing so, several overlooked an important caveat: direct plans are meant for informed investors who can make investment decisions independently.

Not all investors who severed ties with their distributors were capable of investing prudently. To further complicate matters, their chosen alternative for the distributor—experts in media—left a lot to be desired. Experts offering generic opinions on investing in the media doesn’t necessarily qualify as investment advice.

A distributor offering advice based on the investor’s risk profile, investment objectives and horizon cannot be substituted by a media talking head. The need for robust investment advice was accentuated in the last 18 months or so, when markets were at their volatile best. Sadly, some investors have erroneously chosen to blame direct plans for their woes.

The merits of direct plans are indisputable. Indeed, their introduction has gone a long way in democratizing mutual fund investing. 

For investors who need investment advice and services, engaging a distributor and investing in regular plans is a viable option. Conversely informed investors can utilise direct plans and benefit from lower costs. The onus of making the apt choice lies with investors.

Why Investors Must Cheer SEBI’s Initiative On Mutual Fund Disclosures

Last week, market regulator SEBI released a circular that among others, enhances mutual fund disclosures. The new directives have the potential to be game changers.

Let’s start off with the disclosure that has garnered most attention—commission paid to distributors. SEBI has ruled that henceforth half-yearly account statements sent to investors will have information regarding commission paid to distributors. Commission has been defined to include both monetary and non-monetary payments made by the fund company to the distributor. Furthermore, the statement will also have information regarding expense ratios (for both regular and direct plans).   

Some quarters are up in arms against this ruling. While some feel that disclosing commission-related information will push investors towards direct plans, others argue that this is a conspiracy to ease out small distributors. I believe the reservations are a case of stretching the point.

Fund companies pay commissions to distributors for selling their products (and rightly so!); all they need to do is disclose the same to investors (who bear the cost). No one’s suggesting that fund companies must stop compensating distributors. Also, to assume that an investor who is satisfied with his distributor’s service, will turn his back on the same and opt for a direct plan, because the commission is disclosed is a fallacious argument. So long as the distributor adds value, the investor will continue to be associated with him.

In the confusion, most have overlooked what to my mind is the most important ruling—investments in funds by portfolio managers and other personnel. From May 2016, every fund’s Scheme Information Document (SID) will have information related to investments made by the fund’s portfolio manager(s), the AMC’s Board of Directors and other key managerial personnel.

The rationale behind this move is to encourage the concept of ‘skin in the game’. The concept is far more common in the West, than in India. For instance since 2005, the U.S. Securities and Exchange Commission has required fund companies to annually disclose how much portfolio managers invested in the funds they run. At its core, 'skin in the game' is about inspiring confidence in investors. Managers who invest alongside their investors show conviction in their investment approach and acumen. It’s a classic example of putting one’s money where the mouth is. This regulation offers investors insights into funds, and the opportunity to evaluate them in a manner hitherto unavailable.

Then there’s the directive on soft-dollar arrangements. So far, investors have been blissfully unaware of soft-dollar arrangements between fund companies and brokers, and how the same impacted their investments. SEBI has decided that henceforth, soft-dollar arrangements will be limited to benefits that are in the interest of investors, and the same shall be disclosed.

Admittedly, some rules seem odd—it has been mandated that compensation of the fund company’s top brass be disclosed. Likewise, fund companies will have to publish a list of employees whose annual remuneration is equal to above INR 6 million, and also the ratio of CEO's remuneration to median remuneration of employees. I fail to see how these provisions can help investors make better investment decisions. Investors’ interests would have been better served if the method of computing annual remuneration had been disclosed. That way, investors could have comprehended what fund company top bosses are mainly compensated for—growing assets or fund performance.

That said, all in all, the mandated disclosures have the potential to usher in an era of transparency in the mutual fund industry. However, one must understand that a disclosure (read transparency) isn’t an end in itself. Learning more about funds should translate into informed investment decisions, and in turn, goals being achieved. The onus to make the most of the information on hand, lies on investors, advisers and distributors alike.