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Recently, I was going through the Sumit Bose Committee report, which has recommended measures to curb mis-selling and to rationalise distribution incentives in financial products. The committee has proposed sweeping changes in product and commission structure of mutual funds as well. One such change proposed is introduction of reducing asset under management-based trail commission, which I personally found quite eerie.

With mutual funds (MFs), interests of all stakeholders—investors, advisers and asset managers—are aligned (I am deliberately not using the terms ‘distributors’ or ‘product manufacturers’ as I believe that the industry deserves more credit than is given to it). There are very few such businesses in which everyone is working towards a common interest. For instance, in the insurance industry, we all know that term insurance is the best form of insurance; but how many agents or insurance providers are willing to promote term plans? The same’s true for banking. A bank wants to offer low rates on savings accounts and deposits so that it can pocket more margins.

To put things in perspective, the MF industry charges an expense ratio—the cost borne by the investor when she invests in a particular scheme. This cost ranges from 0.05% to 3.0%, depending on different asset classes. Out of this, a major portion is attributed to fund management charges and adviser remuneration in the form of trail commission. What this means is that if the fund does well, in the long term, each one gets a deserving share in the pie.

Let me explain this with an example. A few days back, I saw an advertisement of a diversified equity scheme that has given 80 times returns in the past 19 years. This works out to a huge 25% compounded annual growth rate (CAGR) over the period, while its benchmark, BSE Sensex, has delivered just 11% CAGR in the same period. And this performance is net of all charges. Anyone who remained invested would have created significant wealth. And in the process, the portfolio manager and also the adviser would have earned handsome fees as the remuneration is linked to the value of assets. In the present state of things, all three constituents are happy. But if the adviser is only remunerated for the initial few years and deprived of trail commission, as is proposed in the committee report, she has no incentive to make the investors stay in the fund for a long term, which is very much against the tenets of sound investing.

A good adviser would handhold the investor both during the bull and the bear phases of the market, nudging her to remain invested to reap the benefits in the long term.

This advice, if not implemented, will result in churning and thus mis-selling, thereby creating a bad experience for the investor. On the contrary, the incentive structure should be aligned in such a way that it motivates all concerned to stay for the long haul.

One such proposal could be to increase the expense ratio subject to a higher cap, which means that in the initial years, the investor pays less, and as her assets grow, she wouldn’t mind paying more after a few years because now she is a happy investor.

The adviser and fund manager would also strive hard to ensure that the investor gets a positive experience in the initial years owing to lower charges, which would ensure that she remains invested for as long as possible.

At present, most funds charge much lower than the prescribed limit as laid out by the regulations. Moreover, globally, the market place defines the equilibrium level that is just right for all parties concerned. For instance, in developed nations, most investors prefer to invest money in index funds or exchange traded funds, which are the lowest-cost vehicle, especially when compared to the actively managed funds, which are not able to beat the benchmark post-expenses. In India, however, investors prefer to put in active funds inspite of higher charges compared to index funds as these funds have consistently been able to beat indices over a long period of time. The investor will not mind paying the charges as long as the fund and the adviser are able to generate alpha (higher returns vis-a-vis the benchmark) consistently.

Finally, for any industry to achieve success in the longer term, the customers’ interest has to be at the core of every strategy. More so in the financial services industry, where everything is based on trust. Lately, the very concept of fiduciary responsibility has been abused by the string of mis-selling practices in the MF industry. And this is where the committee report finds its genesis. But by adopting a measure that leads to an adviser misselling products, we are taking a step backward.

Moreover, thanks to the market regulator’s hard hitting measures (ban on entry loads and upfront commission, introduction of direct plans, stay on new fund offer mania), MFs are today a much better place to invest your hard earned money in.

Image Credits – www.goodreturns.in

Original SourceLivemint 

Gajendra Kothari, managing director and chief executive officer, Ética Wealth Management Pvt. Ltd.

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