Commissions to drop if SEBI’s proposal to cut MF expense ratio goes through, say distributors

AIFs nomenclature comes under SEBI's scanner

The proposal to charge a uniform total expense ratio (TER) across schemes of a mutual fund house by the capital market regulator Securities and Exchange Board of India (SEBI) has made many distributors go back to the drawing board. The proposal is expected to hit the revenues of the distributor community. According to estimates by various distributors, commissions may fall by 25 to 50 basis points (bps).

One basis point equals one-hundredth of a percentage point.

Lower commissions?

The consultation paper issued on May 18, 2023, calls for all costs that are outside the expense ratio to be brought within its ambit. These costs include Goods and Services Tax payable by the asset management company (AMC) on the investment management fee, brokerage and transaction costs paid for transacting in securities, and the Securities Transaction Tax (STT).

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Feroze Azeez, Deputy CEO, Anand Rathi Wealth, says, “Including all costs makes the TER transparent and true to label for investors. However, this may mean a contraction of margins for the AMCs. It will be interesting to see how AMCs calibrate the commission payouts in the new regime.”

Put simply, the proposed changes will make TER account for all expenses associated with fund management and will give clear picture of what the investors are paying. When mutual fund (MF) houses have less scope to make money for themselves in the money management business, they will invariably cut down on commissions.

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Mohit Gang, Co-founder and Chief Executive Officer (CEO) of Moneyfront, an online distributor of MFs, says, “Mutual fund commission payouts are going to go down, especially in the case of large mutual fund houses.”
The consultation paper also prescribes one TER for all schemes of an MF house. So, all equity schemes of a fund house will charge the same fee. Instead of TER being charged on the basis of a scheme’s assets under management (AUM), the MF house’s total assets will be considered. This means relatively small MF houses can charge higher TER compared to their larger counterparts.

Azeez says, “Clients may start getting biased advice at AMC level as the commission disparity between AMCs will increase dramatically. This can also become a huge detriment to clients if they deal with distributors who are driven by commissions. This is the problem which SEBI is trying to solve.”

Hybrid funds might see drastic reduction in TER

While the small distributors looking for an extra buck may opt to place business with small fund houses, the bigger fall in TER for schemes of large MF houses may attract direct investors.

“As the proposed TER system calls for asset class-based pricing, hybrid funds that today get charged like an equity fund, and invest in both equity and debt, may see a fall in expense ratio,” says the chief executive officer of an MF house on condition of anonymity. “We will seek clarity on the expense ratio computation of balanced advantage funds which dynamically shifts between equity and debt,” he added.

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These changes in the expense ratio of hybrid funds may also impact the commission payouts. Hybrid schemes are expected to get more investors due to recently announced adverse changes in taxation of debt funds.

NFOs no more revenue spinners

As per the extant framework, MFs can offer higher commissions on new fund offers (NFO) as the TER is based on the scheme’s AUM size. New schemes typically have low AUM compared to well-established ones. As per the statistics given in the consultation paper, out of the total funds mobilised in the 18 months ended September 31, 2022, 27 percent of the money garnered by 47 NFOs of active schemes was through a switch from an existing scheme under a regular plan. This highlights the fact that many distributors may have advised their clients to shift their money with the intention of benefiting from the higher TER (and higher commission) on the NFO. Worse, more than half the money mobilised under regular plans in NFOs got redeemed before completing one year, which makes it clear that the intention in such cases was to pocket high commissions paid for the first year.

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The regulator now proposes that if the distributor proposes a switch from Scheme A to Scheme B (which is an NFO), then in that case, the lower commissions will be payable. For example, if Scheme A offers 50 bps commission and Scheme B, being an NFO, offers 1 percent commission, then despite a switch from Scheme A to Scheme B, the distributor will be entitled to only 50 bps commission.

Also, the fund houses are advised to offer commission either in an increasing trend, with the first year’s commission not being more than 25 percent committed to the distributor for the first three years, or the commission paid to the distributor being equal for all years.

“Making fund houses offer equal or rising NFO commission payouts for the first three years, instead of a large first-year payout, is a good move, as it will ensure that only good NFOs are recommended by the distributors,” says Gang.

If the proposal of uniform TER for all schemes is implemented, then there won’t be any scope for higher NFO TER and higher commissions, say experts. However, if the money is switched from a debt scheme to an equity NFO, there will be revenue implications for the distributors since typically the commissions on debt funds are less compared to equity funds.

B-30 commissions: A thing of the past

Another big blow suffered by the industry is in the higher commissions payable on the business sourced from regions excluding the top 30 cities in India (B-30), almost coming to an end. As per extant norms, MF houses can charge up to 30 bps of the daily net assets of the schemes, if the money is sourced from B-30, subject to certain conditions. The same was being passed on to the distributors. Regulator has found out that to pocket B30 incentives large investments were broken into multiple applications of Rs 2 lakh each, since the B30 incentive was available for retail application amounting up to Rs 2 lakh.

However, going forward, regulator has asked to pay B30 incentives only in case of a new investor (new PAN-based) at the industry level. The commission payable may be fixed at 1 percent of the first application amount, or the SIP committed, subject to a cap of Rs 2,000. Distributors focusing on the B30 cities may see a fall in revenue, going forward. The commissions so payable will be paid out of the investor education and awareness expenses charged on the scheme and will be credited back to the scheme or the Investor Education and Protection Fund, if the units are redeemed in less than one year from the date of allotment.

It is also proposed that payment of upfront commission by investors directly and transaction costs deductible from the investments of investors, may not be permitted. Extant rules allow transaction costs of Rs 100 for existing investors and Rs 150 for first-time investors, which are paid to the distributors. Industry officials say that most large distributors and independent financial advisors (IFAs) have opted out of these transaction costs, but there are a few who are still looking for that extra buck.

Look beyond MFs

While there is no clear estimate of the revenue impact on MF distributors, some distributors say there could a drop in revenues of between 4 percent and 20 percent.

Anup Bhaiya, Founder and Managing Director, Money Honey Financial Services, says, “Low commissions may make new individuals looking to take up this business change their minds, or they will have to become a sub-broker of a large national distributor. The break-even point for new entrants in MF distribution extends further.” Small IFAs have to widen their product offerings by selling insurance, fixed deposits, and other financial products, he adds.

High commission payouts in the insurance business make many contemplate selling life insurance policies too. “Regulatory changes in insurance and mutual fund business over the last decades are good enough reasons to start selling insurance over mutual funds,” says a large distributor on condition of anonymity. “Today’s consultation paper will drive many people out of this industry,” he adds.

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Investors and distributors will wait for final guidelines which will be issued only after deliberations and representations from stakeholders, industry bodies, and investors.

The last date for writing to SEBI with comments on this consultation paper is June 1, 2023.