Consensus on commissions is perhaps never going to be possible
AMFI's Best Practice circular on distributor commissions takes effect from April 1st, 2015 - for those fund houses that choose to adopt it in toto. There has been intense debate within the industry over the last few weeks as several clauses of this circular were taking shape, and there is a lot more debate after the final circular has been issued, because the nature of the issue at hand is such that there never will be perfect consensus across all industry stakeholders on all aspects. Commissions are and will continue to be one of the most emotive and contentious topics within the industry. The industry is deeply divided as a consequence of the process through which this circular came into being. Some AMCs have decided not to adopt it, some have decided to take the spirit of the circular but not necessarily the letter, and many have decided to adopt it fully, at least in letter.
6 key guidelines at the core of this circular
There are essentially 6 key guidelines on pricing that form the core of this circular:
Upfront commissions capped at 1% for full fee products where the TER is above 1%, and is capped at TER for lower fee products Upfront for B-15 towns to be cumulative of above 1% cap + B-15 incentive (which comes to around 2%). Effective cap on upfronts in B-15 towns therefore works out to 3%, while it is 1% in T-15 cities Upfront + Trail in year 1 cannot exceed distributable TER (total TER minus scheme operating expenses) Trail in subsequent years cannot exceed year 1 trail All forms of marketing support to distributors to be included within the cap mentioned in 3 above Repricing of existing books not permitted. Existing trail on old assets will continue.
What is the objective of this exercise?
To understand the merits of each of these points, we need to look at the stated agenda that AMFI was trying to address, and then see how well these points actually address the stated agenda.
AMFI says in its circular that SEBI was concerned about unhealthy trends in upfront commissions and upfronting of trail commissions particularly in closed ended funds. There is specific reference to adverse media reports of mis-selling induced by high commissions. AMFI clearly acknowledges that this circular is a consequence of SEBI's moral suasion on this issue - which, when shorn off niceties means that SEBI was breathing down AMFI's neck to "do something" about high commission induced mis-selling.
From what I recall of adverse media reports, they were shouting hoarse about high commissions on closed ended funds consequent to fund houses decisions to "upfront" trail of 3 years. All media headlines of 6% and 8% commissions invariably talked about sales excesses in closed ended funds. I really don't recall any media report that talked about mis-selling induced by 1.5% upfront on an open ended fund.
The point that many industry participants are asking therefore is why AMFI decided to extend the brief of this "moral suasion" induced circular beyond upfronting of commissions in closed ended funds. A simple best practice circular that purely dealt with upfronting would perhaps have done the job required.
Is SEBI really against upfront commissions?
Talking of "moral suasion", it is only fair that we take a step back and look at SEBI's attempt at moral suasion. SEBI, in the era of Mr.Bhave, had a very firm view against upfront commissions. It banned entry loads thinking that would kill upfronts. Then when it saw upfronts coming back, it informally set a limit of 0.5% as upfront and 0.75% as trail on equity funds - and all AMCs were expected to fall in line with the pricing formula - which they did. Then there was a change of guard at SEBI and under Mr. Sinha's watch, this informal price band was given a go by and market determined upfronts and trails made a comeback.
In its efforts to "energize" distribution, SEBI itself came up with a formula that effectively allowed AMCs to pay an additional 2% upfront commission in B-15 towns, over and above existing commissions, in order to induce higher sales in these less penetrated markets. SEBI's own working papers gave an example of how its additional TER for B-15 towns will allow upto 2% additional as upfront commission - the workings did not suggest trail commissions.
Then came the phase of closed ended fund launches. This began towards the end of 2013 and was in full force right through 2014, with SEBI giving approvals to series after series of closed ended fund launches, making a bit of a mockery of its own stated stand of asking AMCs to have compact product ranges with no overlapping products, and asking trustees to only approve new launches which are clearly distinctive from the existing fund range. Approvals for more closed ended funds were coming fast and thick, even as media reports highlighted potential mis-selling induced by upfronting of commissions on these closed ended funds.
If SEBI is now expressing concerns about upfronting of commissions - well, its better late than never, I guess. But for SEBI to express concerns about upfront commissions - that I find a little difficult to fathom. It's the same SEBI, under the same leadership that acknowledged that upfront commissions are the best way to "energize" distributors and get them to penetrate deeper in B-15 markets. Are we therefore suggesting that upfront commissions "energize" distributors in small towns, but induce mis-selling in large cities? AMFI's circular specifically retains the existing B-15 upfront commission arrangements - which is really institutionalizing this thought process that upfronts are bad in big cities but good in small towns.
So the question really is whether moral suasion was on upfronting alone or on upfront commissions as well. And if indeed SEBI's moral suasion covered upfront commissions as well, did AMFI ask SEBI to clarify its stand once and for all on whether it likes or dislikes upfront commissions? SEBI can't possibly encourage upfront commissions in one set of towns while frowning upon the same in another set of towns in the same country.
Is this just an interim step or the final end game?
There is a separate exercise that the Finance Ministry has anyway undertaken to review commission and incentive structures across all financial products, with a view to see how best to harmonize them and ensure that they are aligned with investor interests. AMFI and SEBI are anyway providing inputs to this committee and will therefore be aware of progress on these deliberations. When this larger exercise is anyway in process, perhaps AMFI could have come out with a specific circular that deals with the core issue alone - upfronting of trail in closed ended funds. Once the larger picture on harmonization of commission structures across all financial products is known, AMFI could have then steered MF distribution structures to align with whatever this larger picture is. That would have given all stakeholders confidence that we are finally moving towards a stable and predictable commission model, on the basis of which distributors can make their longer term plans. The reason why this is so important is that if you ask distributors, their angst is not so much on specific clauses of this circular or of any previous circulars - their issue simply is that there is too much experimentation going on for several years on distributor revenue models, which does not help anyone make long term plans with any confidence. In this round, several senior executives from several fund houses have put in a huge effort in coming up with what we see as the final circular. But, I really doubt whether this is the end game. This could well be an intermediate step towards an all trail model - we will perhaps know the end game only when the Ministry makes its decisions on commission structures across all financial products.
Perhaps AMFI missed an opportunity to impress upon SEBI the need to await the Ministry's larger decisions before going ahead with this best practice circular. Then again, with SEBI distancing itself from this circular, one really does not know whether SEBI wanted a circular with such granularity or did it only want the issue that was getting bad press to be dealt with - which is upfronting of commissions on closed ended funds.
The circular itself
Be that as it may, we have a circular and it is now in force. Some of the aspects of the circular are absolutely spot on and some perhaps don't fit into the stated agenda. To issue a best practice guideline that says that distributor commissions in all forms should not exceed distributable TER is absolutely sensible. All industries must put in place checks and balances that discourage a "race to the bottom", which is what unchecked commissions can do.
The cap of 1% on upfront commissions in itself may not be such a bad thing for the industry. It is the fact that there are differential caps for T-15 and B-15 that rankles. It is also a belief that this is an interim measure that unsettles distributors, who would rather have a stable plan spelt out and then held in place for several years.
There are several large distributors who are upset about this cap. Fund houses on the other hand are upset that many of these large distributors contribute less towards industry net sales and more towards gross sales - thus adding little value to fund houses but a lot more value to their own bottom lines. In this context, there is a belief within some sections of the fund industry that if some of these large distributors threaten to go slow on MF sales, well so be it.
On the other hand, distributors who consciously embraced an all trail model in the past couple of years have good reason to be happy. Their stand is getting vindicated and their business models will face the least disruption from this circular. Clearly, seeing the writing on the wall and acting proactively is the most prudent policy. I have been consistently writing in these columns over the last few years that a full trail model is where I see the industry eventually heading. We are, with this circular, one step closer to what I believe will be the end game.
Have we now tackled churn?
If capping upfront commissions is seen as a way to curb churn, I am not sure we will achieve the desired outcome. If upfront commission is 1% and trail is 1% for year 1 and onwards, there is still a 1% differential between commissions for year 1 and year 2. As long as an arbitrage exists, there is a potential for commission induced churn. The arbitrage was bigger, now its narrower. But its still there and is still good enough to induce churn. The only way one can truly tackle churn is an all trail model - where there is no difference in commissions between years 1, 2 and 3.
There's a googly in this circular which in my view does nothing towards the stated agenda but on the contrary, may do exactly the reverse. There is a guideline which prohibits repricing of existing assets. Now, how does a repricing conversation between a distributor and a fund house on existing assets induce him to mis-sell products? And if there is no connection with commission induced mis-selling, why does this stipulation come into this circular - whose stated agenda is to tackle commission induced mis-selling? On the contrary, if distributors know that they cannot expect to have any repricing conversations on existing assets, are you not inducing them to go out and try to churn these away to get substantially higher trails on new sales? So what have we really achieved with this one? I suspect this is one stipulation that may come up for review in 3 months, when AMFI has anyway promised a review.
Don't let SIPs give away market share to ULIPs
Certain other aspects need to come up in the review 3 months down the road - these are exceptions that ought to have been given but were not. SIPs are the lifeline of retail distribution efforts. There can be a persuasive case made to enable some form of "upfronting" for retail SIPs (a threshold can be agreed) to make it a commercially viable distribution effort. Yes, we all know that in the long term, trails on SIP build a healthy annuity income for distributors. But at the same time, the industry does want as many feet on street across the country (including the big cities) selling retail SIPs. That effort can get a big boost if we find a way to continue with some form of "upfronting" to give retail distributors a more immediate reward for their initial sales efforts.
In this context, we must bear in mind that the industry has an old competitor with a new improved look who is hungrily eyeing the turn of events in the MF space. ULIPs have now become cleaner, their cost structures have become more sensible, long term investments in ULIPs actually prove more cost effective than many funds with TERs of 2.5% to 3%, and commissions there are substantially higher at present. The industry needs to recognize that making SIP mobilizations less remunerative is potentially allowing a competitor to open up a flank and take away market share that the industry so painstakingly won over the last 5 years. This ought to come up for review within the next 3 months, if not sooner.
Fight for your rightful share in 80C - don't give it up so easily
Likewise, ELSS competes with many other products within the 80C bucket. There needs to be more thought from the industry on how it wishes to retain its sales competitiveness vs competing products. ELSS does not operate in a vacuum. The industry needs to fight for its rightful share and not give it up so easily. Checks and balances can always be looked into - you can for example stipulate that "upfronting" for ELSS products will only be allowed upto Rs.150,000 per PAN, to avoid abuse. This is a case that ought to be reviewed sooner rather than later.
Look at it another way - if you permit "upfronting" in SIPs and ELSS with appropriate checks and balances, well you have found a way to keep retail distributor interest alive and kicking, while at the same time curbing some of the misdirected efforts of some large distributors who notch up great gross numbers but poor net numbers. Isn't that what the industry wants?
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