The reason is they are beholden to large distributors to sell their schemes. And these distributors are more interested in churning and therefore upfront commissions. They have no interest in promoting long-term investment in equities and earning from trail commissions
Upfront commission paid out by mutual fund houses to distributors has always been a bone of contention. Last year, industry body Association of Mutual Funds in India (AMFI) scrapped the plan to ban upfront commission. Last year, after the market regulator brought out a slew of reforms to ‘revive’ the fund industry, we mentioned that independent financial advisors (IFAs) contribute the most to new equity fund inflows especially from beyond 15 cities and yet the regulator chooses to ignore this ‘small’ distributor community by coming up with regulations that harm their business, allege smaller distributors (Read: Mutual fund regulations: Who contributes the most to equity inflows is overlooked
). Trail commissions, though lower than the one-time upfront commission, support their business model as they establish long-term relationships with their clients. Distributors, on the other hand, look to earn higher in the form of upfront commissions through excessive churning of their clients’ portfolio. This practice in not only damaging for the client but affects the industry as a whole.
Chilukuri KRL Rao, a small distributor from Hyderabad, has drawn our attention to the ground-level practices that hurt investors and smaller distributors. He says, “Small distributors who cater mainly to the small retail investors are willing to work even with low trail commissions due to their cost efficient business model. But, the main hindrance to the growth of the industry seems to be the way these incentives are being paid to a distributor.”
A number of independent financial advisors (IFAs) also support a ban in upfront commission. “High upfront commissions lead to the practice of excessive churning by unscrupulous mutual fund distributors in order to earn themselves a higher commission. This practice of fund houses offering a higher upfront commission and lower trail commission is detrimental to many honest distributors who promote investing in mutual funds for the long-term. They lose out as because of the upfront commission they earn lower in trail commission,“ points out Rao.
Trail commission is beneficial to distributors who are able to keep their clients invested in a particular scheme for the long-term. In the table show below, Mr Rao shows how small distributors benefit in the long run with just trail commission. The table portrays a trail only model of Franklin Templeton Mutual Fund where in they pay a trail of 1.1% perpetually. Distributors lose out on earning a higher commission from the second year onwards when they earn a high upfront commission.
Many other IFAs support this “trail only” model by Franklin Templeton MF. In a discussion forum on wealthforumezine.net many IFAs have voiced their opinion on the “trail only” commission model. Vikas Gupta, a distributor from Rohtak says, “I am of the firm opinion that upfront brokerage must be banned in MF industry to curb all types of mis-selling and trail commissions might be increased accordingly to boost ethical selling.”
Another IFA from Mumbai, H Manohar Shenoy, says “Trail model is the best method, as one is required to sell the right product in a right way. This will enable an investor to remain invested longer. It is in the interest of IFAs and the mutual fund Industry. Upfront commission, as we all know, encourages bad practices.”
For retail investors as well, this would be beneficial as distributors will not be lured to offer them schemes having a high upfront commission and/or ask them to churn their mutual fund portfolio on a regular basis. Moneylife
has written several times in the past on this unscrupulous practice. Recently we saw certain fund houses paying an upfront commission as high a 6% to distributors for their RGESS (Rajiv Gandhi Equity Savings Scheme) eligible mutual fund schemes.. Hence, to earn a higher income, distributors would naturally pitch the schemes. These schemes saw applications as high as Rs10 lakh coming in from HNI clients. (Read: High value applications perverting RGESS, while SEBI remains mum
Banks have also been accused of excessive churning of client portfolios. We had highlighted this in November 2010, (Read: Now, banks blamed for continuous equity mutual fund outflows!
) where banks were excessively churning mutual fund portfolios to earn commissions. But even then neither the fund companies nor the regulator seemed concerned.
Why don’t large distributors support the ban on upfront commissions?
Fund houses usually pay 0.70 to 6.5% as upfront commission to distributors to push their equity schemes. This is an additional amount of money which AMCs pay from their own pockets to distributors. Apart from this fund companies pay a trail commission as well which ranges from 0.4% to 0.6%. This huge difference in commissions makes larger distributors resort to excessive churning in order to earn higher in the form of upfront commissions.
According to Mr Rao in his letter, “Trail only model benefits investors and small distributors whose assets are known to be for a longer term. Influential distributors get a far higher upfront commission than what a small distributor gets and hence, this is one of the main reasons for not doing away with upfront commissions.”
Supporting this fact, Subhash Chander, a distributor from Rohtak in a discussion forum on wealthforumezine.net says, “National distributors get lot more than IFAs as upfront brokerage, contests, overseas trips, gold, movie tickets, pizza parties & more trail while IFAs have to be satisfied with lesser trails second year onwards.”
Mr Rao also mentions that top fund houses which can afford to pay huge upfront commissions to promote their schemes may not go in for the “only trail” model and increase the trail commissions, as paying of trail commissions would reduce the profitability of the fund house. Also, there is lack of transparency in the upfront commissions paid to distributors. Therefore, some unscrupulous elements would use this to their benefit. “Trail commission is well published and transparent; hence, the scope for such manipulations is almost nil and is not a very profitable option for such unscrupulous elements,” says Mr Rao.
Even KN Vaidyanathan, an executive director of SEBI, in an exclusive interview to Moneylife
in May 2010, on the ban on upfront commission in the form of entry load, spoke about the benefit of a trail only model saying, “People confuse between upfront and trail. Business models based on upfront will die. Irrespective of how the dispute between ULIPs versus mutual funds works out, the writing on the wall is clear. Upfront commissions and entry loads will become zero. It is a matter of time. Therefore, what it leaves us with is trail commissions. There is nothing to match the attractiveness of trail commission of mutual funds because the trail is on the total kitty, not like the upfront commission on a single product. But that means everybody has to think long term, especially after upfront commissions are gone” (Read: “Upfront commissions were making everybody think short-term. They will think long-term now