Column : Error of 2.25% commission

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SummarySebi's proposal to introduce greater transparency in the commissions earned by mutual fund distributors has met with resistance from the latter. Mutual funds ride on the network of distributors such as banks, brokers and financial consultants to reach out to investors.

Sebi’s proposal to introduce greater transparency in the commissions earned by mutual fund distributors has met with resistance from the latter. Mutual funds ride on the network of distributors such as banks, brokers and financial consultants to reach out to investors. Distributors earn fees as a per cent of the investments collected by them. Typically, 2.25% of the investments made into an equity mutual fund scheme goes to the distributor. This is called the entry load. So, if you invest Rs 1,000 into an equity fund, you immediately lose Rs 22.5 to the distributor and actually invest only Rs 977.5. There are funds (such as those by Quantum Mutual Fund*) that have decided not to use intermediaries as distributors so that the investor gets to invest the entire Rs 1,000. In the US, Vangaurd pioneered such a concept. However, in India, most of us still choose to pay a commission to the distributor. This is in spite of the fact that in January 2008, Sebi mandated a zero entry load in cases where investments are made directly (without the intermediary distributors). According to Sebi, only 4-5% of the mutual fund applications are made through this mode.

The problem is that in spite of Quantum and Sebi’s initiative, this commission payment is, sort of, involuntary. The user mostly does not have a choice. Because, by default, if you approach your broker or take that call from a relationship manager from your bank, in all likelihood you are not even told that 2.25% would be shaved off your investment the moment you signed in. Now, Sebi says that the entry load or call it brokerage fees should be negotiated between the distributor and the investor. Just like you would negotiate the brokerage for any deal through a broker. So, what is the fuss about?

The industry says that the customer will not pay the brokerage because the investor is not mature enough. In reality, the distributor finds it too embarrassing to charge a brokerage after presenting himself as a friendly adviser. Ditto for the relationship manager from your bank. I find this most amusing.

Besides providing financial investment advice, the local financial consultant or broker is willing to send runner boys to fill forms, get signatures, photocopies, collect cheques, provide research reports, investment tips and live market gossip. And, he does not ask you to shell out even a “khota sikka” for all this.

The investor on the other hand remains happily oblivious of what he is signing — the paper work is mind boggling to anyone who would care to read—or often even what he is investing into. The financial consultant/broker/distributor/relationship manager would ofcourse discourage you from reading any of the offensive prose by implying that this is the way the world works and he would “take care of all the details”, including maintaining all records.

Are investors not educated enough to understand that they do not understand what they sign? Or that all this back-office work and advice could be for free? Surely, they do understand. But, they believe that the little that the distributor earns is well worth the anticipated returns. It is a small price for outsourcing the knowledge besides the tedium. When the markets tank, the distributor continues to provide “free” advice. It is a sadly happy equilibrium.

Sebi’s new proposal would break this equilibrium. And, it should. The retail investor needs to ask his broker more questions on the service provided and on the commissions that accrue to him indirectly. Investors do not lack maturity. The timing is not inappropriate as AMFI would have us believe. It is the right time for investors to save some money while investing.

Most people who buy a house go through an estate broker and pay a brokerage that is negotiated. Surely, investing into mutual funds is not more complicated than buying a piece of property.

While investors are willing to pay brokerage to an uneducated real-estate broker, I believe they will resist paying the qualified professional of a distributor anything close to 2.25 % they get currently. The reason is that distributors do not provide any advice or service worth the 2.25 % implicit price. Most financial consultants believe the investor is not mature enough to pay anything at all. But the feared refusal to pay the entry load probably reflects the quality of the service rendered more than the lack of maturity of the investor.

When investors have to explicitly discuss the fees paid for services rendered, they would be more careful in evaluating the options, valuing the services and hopefully reading what they are made to sign. Only discerning investors who invest into financial instruments like they would invest into their own homes would make the financial markets efficient. Only the enlightened investor can save us from scamster promoters and pliant auditors. Regulators can only play a marginal role by nudging the retail investor out of his deep slumber.

The author is managing director & CEO of Centre for Monitoring Indian Economy. *Disclosure: He is also an independent director at Quantum Asset Management Co, a mutual funds company and Geojit Financial Services, a stock broking company that also distributes mutual funds

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