Why Indian Fund Companies Shouldn’t Fear Greater Transparency

Media reports suggest that several Indian fund companies are at loggerheads with market regulator SEBI. The latter wants to increase transparency by disclosing commissions paid to distributors in investors’ statements of accounts. On the other hand, fund companies believe that doing so will be detrimental to their interests. According to reports, industry body AMFI has communicated its reservations to the regulator.

Reasons for opposing the move are varied: some fund companies think disclosing commission-related information will dissuade investors. Others feel that bombarding investors with too much information will be detrimental. 

To my mind, the concerns raised by fund companies are both misplaced and weak. To begin with, the proposal doesn’t alter the working of the fund industry in any manner. 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 should stop compensating distributors.

As for fears of investors becoming upset by learning about commission payments, or becoming confused on account of too much information—those are weak arguments. Fund companies would do well not to underestimate the investor’s intellect. To assume that an investor who is satisfied with his investment will turn his back on it, because the agent’s commission is disclosed is a fallacious argument.

When an investor invests in a mutual fund, effectively he engages a fund company to manage his monies. The fund company charges a TER (comprising everything from operational expenses, the fund company’s fees, to the distributor’s commission) for the service. An unambiguous disclosure will aid investors better understand the fund’s working, and thereby make informed investment decisions.

For instance, a fund company which keeps costs (including fees and commissions) low and thereby enhances the fund's returns can benefit by communicating the same to investors. It can be safely stated that such disclosures will go a long way in winning investors’ patronage.  Conversely, the investor has a right to know if his fund is losing its competitive edge on account of exorbitant commission pay-outs.

Case for more disclosures

I’m surprised that in its quest for greater transparency, SEBI didn’t start at the top of the pyramid i.e. with fund companies. There is a strong case for making public, information related to the fund company’s compensation policy for its investment staff (portfolio managers and analysts), and also information regarding a portfolio manager’s personal investments in funds he runs.

Taken together, the two can reveal a lot about the fund company’s culture, its attitude towards investors, and a manager’s commitment to his fund—all of which can be vital in helping investors make better decisions. 

Admittedly, from the perspective of fund companies, revealing information that hitherto was private can be discomforting. But it is in their interest to embrace this change. Greater transparency isn’t an end in itself. The intent is to improve investors’ investment experience, and in turn make mutual funds more appealing. And when the investor wins, so will fund companies.

Much ado about 'no entry load'

All right. So, the Securities and Exchange Board of India (SEBI) has decided that mutual funds will no longer be permitted to charge an entry load. And all hell has broken loose! Newspapers are carrying articles with comments from 'experts' and 'senior officials' at fund houses running down the move; a lot of emphasis is being laid on how this step will hurt the mutual fund industry. But is that correct? Can a step that is evidently pro-investor be detrimental to the industry?

Let's take a look at what SEBI has proposed. Following is an extract from a press release posted on SEBI's website:

"There shall be no entry load for the schemes, existing or new, of a Mutual Fund. The upfront commission to distributors shall be paid by the investor to the distributor directly. The distributors shall disclose the commission, trail or otherwise, received by them for different schemes/ mutual funds which they are distributing or advising the investors."

The guideline suggests that the practice of fund houses deducting an entry load (from the sum invested) and paying the same to distributors (investment agents/advisors) as upfront commission will be discontinued. Instead, the investor will have to compensate the distributor for the services rendered. Also, distributors shall be obliged to reveal the total commission they earn from various mutual funds.

So let's see, what's causing all the hoopla? Have distributors been deprived of their livelihood? Does the regulation suggest that henceforth distributors will have to treat selling mutual funds as a philanthropic activity? No. So why all the fuss? Here's why. Thanks to this step, distributors have been made accountable. They can no longer operate with a "the more I sell, the more I will earn" mindset. With an assured income of 2.25% or thereabouts from the entry load, aspects like quality of advice and service were rarely granted any importance. However, that modus operandi is now history. Several distributors will have to kiss a tearful goodbye to the 'easy money' route. And this is where all the agony stems from!

Any distributor who is confident about the quality of services he offers, should welcome this step. Nowhere does the guideline suggest how much income the distributor can demand from the investor. So if the distributor provides quality advice that is consistently in the investor's best interests and backs it with top-notch service, he could potentially demand more than the 2.25% that was available to him via the erstwhile entry load. Hardly a reason to complain!

Now for the second part of the guideline - disclosing all commission earnings. Again, distributors only have themselves to blame. Having built a reputation for selling mutual funds that offer them the highest commission, mis-selling continues to be common practice in the mutual fund industry. SEBI is simply trying to incorporate greater transparency in the investor-distributor association. Distributors who do not engage in any malpractice have no reason to fear. They should be able to justify why they are recommending a given fund vis-à-vis another.

Some fund houses are apparently aggrieved since they believe that the mutual fund industry will suffer, since distributors will gravitate towards insurance products offering better commission. Hence fund houses will end up with lesser assets to manage. Of course, a smaller asset size translates into lesser income for the fund house.

Here's a counterargument - if the mutual funds on offer are attractive enough and can aid the investor in achieving his investment goals, he will demand them and thereby create a demand. And the onus to ensure that funds are attractive lies primarily with the fund house. Also, if a fund house feels that distributors deserve to be better compensated, it is free to cough up additional benefits out of its own pockets. Remember the regulator only stipulates how much expenses can be charged to the fund (i.e. borne by the investor). Any fund house/AMC which believes that distributors are being short-changed, should feel free to reward them out of its own coffers.

Time and again, fund houses have failed to act in the best interests of the investor. Their partisan attitude towards distributors and indifference towards investors has been disappointing to say the least. Let's hope this time around better sense prevails and they don't create any roadblocks in the implementation of this directive.

As for investors, they couldn't ask for more. First, they were given the opportunity to invest directly with the fund house, thereby bypassing the distributor and avoid paying an entry load. Now with the guideline to scrap the entry load, they can negotiate with the distributor and arrive at a fair price for the latter's services. The onus to make the most of this opportunity lies with investors.

Kudos to SEBI for taking a stand for investors!

Distributors and fund houses - keep your chin up. This round goes to investors!