Death Knell For Retail Distribution?
Sebi’s move to reduce the profit margins of AMCs for the sake of retail investors is going to end up curtailing distributor commissions
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Let’s consider the complex Mutual Fund ecosystem in India for a moment. On the one hand, we have investors who have deployed roughly Rs. 24 lakh crores into them. This money is invested with 39 AMC’s (Asset Management Companies) – ranging from behemoths like HDFC and ICICI Prudential who boast of assets exceeding Rs. 3 lakh crores apiece, to the relatively inconsequential players like Taurus, Shriram and Sahara, who manage lesser than 500 Crores in assets on last count. The proverbial “big boys” wield substantial clout, with the top 8 players controlling more than 75% of the assets.
Next in line, we have the trusty army of an estimated 120,000 IFA’s (Independent Financial Advisors) who’ve played a pivotal role in taking Mutual Funds into a market that still by and large swears by traditional postal schemes and life insurance. Another 1168 RIA’s (Registered Investment Advisors) have chosen to bravely (or quixotically, in hindsight?) forsake embedded commissions in favour of charging fees to customers directly. Anecdotal evidence suggests that most of them are struggling to collect fees now, especially with the frustratingly tepid show that the equity markets have put on since early last year. Recent trends in technological innovation have thrown a new player into the fray – the deep-pocketed, “DIY” investment platform that’s armed with burn capital and requires no cashflow for the next several years to survive - and can therefore sanctimoniously present calculations of how commission savings stack up over the years; all the while conveniently ignoring the pernicious behaviour gap that erodes billions of dollars in unadvised investor wealth every year!
Complicating the turf further is the fact that Asset Management Companies offer “direct” variants of the “regular” schemes distributed by IFA’s, in effect competing with the very people who are taking their product to the market – with a “cheaper variant of the same model”, so to speak. And finally, we have the capital markets regulator SEBI controlling Mutual Funds with an iron fist; while AMFI acts as the apex body that is representative of the AMC’s. And guess what? After all this hubbub, Mutual Fund penetration in our country of 134 Crore people stands at a paltry 1.5 per cent, with roughly 2 Crore unique investors. To put this number in perspective; 75 Crore Indians have bank accounts, and 35 Crore have insurance policies. In fact, our Mutual Fund AUM to GDP ratio is an abysmal 11 percent – well below the world average!
Prima facie, growth numbers look promising. Industry assets have surged quite spectacularly in the last five years, growing threefold from Rs. 8.25 lakh crores in March ’14 to Rs. 23.79 lakh crores on last count. An estimated Rs. 8,055 Crores flowed into Mutual Funds on autopilot in March ’19, via SIP’s (Systematic Investment Plans) alone. But in a complex ecosystem such as this, it rings true that the flapping of the proverbial butterfly’s wings could unsettle the picturesque scenario just as quickly – and on April 1, 2019, the wings may just have flapped. But first, let’s go back a few months.
The month is August 2018, the occasion is AMFI’s 2nd Annual Mutual Fund summit at Mumbai. The crème de la crème of the industry has gathered to hear SEBI chief Ajay Tyagi speak^. But by the end of his talk, the room has a distinctly worried undercurrent - because Tyagi has just called into question the profitability of large Asset Management Companies which stand at a very healthy 40%-50% of top line, and also declared that there is distinct elbow room for rationalizing the TER’s (Total Expense Ratios) of Mutual Fund schemes to pass on the benefits to investors in the form of higher net asset values. For those not aware, the expense ratio of a fund is the percentage of your investment that is shaved off every year to provision for the fund’s operating and distribution costs. SEBI promptly constituted a six-member panel to “closely examine” TER’s, and what followed on October 22nd ’18 was the circular that many have since dubbed the death-knell for retail Mutual Fund distribution in India.
On April 1, Mutual Fund distribution received a double whammy in the form of reduced commissions and staggered pay-outs, respectively. Skimming over the details of the circular, let’s consider the two salient points that relate to the reduction in TER’s described above. First off, the circular stipulates that “MFs/ AMCs shall adopt full trail model of commission in all schemes, without payment of any upfront commission or upfronting of any trail commission, directly or indirectly, in cash or kind, through sponsorships, or any other route”. In effect, this move slices away a critical chunk of a distributor’s income in one fell swoop. An example will help illustrate.
Consider Rahul, a Mumbai based IFA (Independent Financial Advisor). He’s recently started a retail Financial Advisory business. In the spirit of customer centricity and conflict-free advice, he’s decided to pass up high-commission but value eroding products like traditional life insurance; focusing instead on Mutual Funds and pure-risk insurance products such as Term and Health insurance. He meets Jaspreet, a first-time investor, who follows Rahul’s advice and invests Rs. 1.5 Lakhs in a leading large-cap equity oriented Mutual Fund. Since Jaspreet is new to Mutual Funds, he’s naturally fearful and sceptical. Jaspreet’s family has never looked beyond traditional postal schemes and life insurance, and so Rahul needs to devote a sizeable amount of time and energy to hand hold Jaspreet and give him the comfort to cut his first cheque for a Mutual Fund investment. In fact, he’s had to drive down to Jaspreet’s office a couple of times as well. Once the fund application is logged in, Rahul is paid 0.5% of the application amount (or Rs. 750) by the Asset Management Company, and another 0.75% per year subsequently accrues as a monthly “trail” income. This works out to a further Rs. 95 – Rs. 100 or so per month, depending upon the average folio value through the month.
Post the implementation of the circular in October ’18, Rahul’s upfront commission pay-outs come to a screeching halt, leaving him with only the recurring trail commissions on the investments sourced by him. Compounding the problem is the fact that 70% of equity assets in India don’t even age beyond two years; and so, the odds are that trail pay-outs will not even continue beyond 24 months! Suddenly, the unit economics of serving a retail client don’t quite add up.
As a matter of fact, this logic applies all the more to SIP’s (Systematic Investment Plans), that result in a very gradual accumulation of trail income-generating assets; it typically takes several months (or years) for a distributor to recoup the acquisition costs, leave alone achieve customer-level profitability. With the regulator now only allowing SIP-commission upfronting on applications of “up to Rs 3000 per month, per scheme, for first-time investors in mutual fund schemes”, the economic viability of newly established SIP-based retail distribution models gets called into question. And it’s not just the IFA’s who are concerned, but AMC’s too. As Radhika Gupta, CEO, Edelweiss Asset Management points out: “In general, funds getting cheaper make the product better for the investor, and anything that is good for the investor should be good for the industry. That said, distribution plays a critical role in bringing investors to the table, and distribution partners, particularly retail IFAs have to get compensated fairly. My concern is that the economics today for a retail IFA make it fairly difficult to sustain the business in the early days, and I hope this doesn’t dissuade new entrants from joining the business”
Aashish P. Somaiyaa. MD & CEO - Motilal Oswal AMC concurs, saying: “In my worst-case analysis, we are running a risk of disenfranchising retail investors from advice and service. We must appreciate that in a city like Mumbai - or for that matter most cities in India, the remuneration earned by collecting a SIP of Rs 1,000 doesn’t even pay the intermediary for the conveyance costs incurred in the process!”
The second material clause in the circular is, of course, the actual cut in the TER itself. The regulator’s intention was to reduce the embedded costs borne by Mutual Fund investors by up to 20%, and the premise for rolling this out certainly wasn’t flawed – Asset Management Companies do in fact benefit greatly from economies of scale. Suffice to say that the quantum of time and resources required to manage a fund that’s Rs. 30,000 Crores in size wouldn’t be exponentially higher than those required to manage a fund that’s Rs. 15,000 Crores smaller – and so the incremental expenses really just add to the AMC’s profitability in the end. In other words, the cost of investment management does not increase in the same proportion as do the assets of a fund, and the curve really just flattens after a point.
In theory, SEBI’s move should play out wonderfully well. As originally intended, Asset Management Companies absorb the hit in the TER’s at the cost of their profitability by trimming the fat off their operations. Distributors, though put on the backfoot by the sudden drying up of upfront commissions, pluckily solider on and adapt their businesses to the altered cash flow scenario. Life goes on. Except, of course, that isn’t quite how things are transpiring.
“Most AMC’s are indicating that the entire reduction in TER reduction will be passed on to distributors. The impact can be in the range of 20%-40% on Equity and Balanced Funds; and it will be much higher in case of close ended funds”, says Roopa Venkatkrishnan, a leading Mumbai based IFA with over 900 Crores of Assets Under Management.
This turns the situation on its head, because the same economies of scale that exist within the asset management business do not, in fact, exist within the retail distribution space. If anything; the retail distribution business model, which is mainly SIP based, follows a “hockey stick” sort of curve in which a lengthy period of low to negative profitability is followed by robust growth – but only once a certain scale is breached.
Is the circular missing some vital clauses?
Yes, SEBI’s diktat is well-intentioned, but the circular itself is glaringly incomplete in terms of defining the actual modus operandi of the TER cut. In other words, while the reductions and their quantum have been clearly defined, AMC’s have been given carte blanche in terms of how to actually bring about the cut – in effect, as many would believe, throwing the distributors to the wolves.
As Dhruv Mehta, Chairman, Foundation of Independent Financial Advisors (FIFA) observes: “Most of the revenue hit is going to be passed on the distributors - especially by the large AMC’s. Thus, distributors’ top line as well as bottom line will drop. This is not line with the regulator’s intent of passing on scale benefits to investors. AMC’s benefit the most from the rise in scale of the industry and growth in AUM. A 15%-20% drop in a distributors top line could well lead to 30% -40% drop in their net income, with catastrophic consequences for them”
Other dubious practices appear to be mushrooming quietly too. Said a leading Advisor who did not wish to be named: “There are early indicators that a few large AMC’s are pricing a distributor’s ‘old book’ and ‘new book’ differently. The old assets are being priced at a lower trail commission, with a higher trail commission being offered for incremental assets. This is a blatant malpractice because the fund will charge the customer a uniform TER across its total asset base! Not only does this undermine the years of toil that vintage Advisors have put in to get to where they are today, revenue-wise; it will also encourage unnecessary churn from ‘old assets’ to ‘new assets’; which will defeat the very spirit of transparency and investor centricity that the regulator is trying to achieve”
Needless to say, these are all grave issues for an industry which, at least for the retail segment, has relied heavily on distributors to rope in the new moolah and service existing clients.
Bracing for impact
It only takes a cursory glance at message boards on portals such as Cafemutual#, to recognize the extent that this move has irked distributors. Many are considering exiting the trade altogether, and greenhorns who were just setting up retail outfits are pressing the panic button and nipping their plans in the bud. As Venkatkrishnan observes: “The move will deter new distributors from entering the mutual fund industry. Additionally, lots of existing distributors will move to selling Real Estate, Fixed Deposits & Insurance Products where commissions are lot more lucrative”
Says Radhika Gupta of Edelweiss: “Life now gets much harder for the retail IFA – which is unfortunate and needs to be addressed, because the country has a shortage of advisors… a severe one”
Mehta of FIFA notes that the large institutional players are already moving towards high commission Insurance, AIF (Alternative Investment Funds) and PMS (Portfolio Management Services) products. “It is the Independent Financial Advisor focussed on Mutual Funds and Retail Investors who will take the biggest hit”, he explains, pointing to the lack of product options available to the small-ticket size Advisor other than Mutual Funds.
There are questions related to this move that hang uncomfortably in the air. The first relates to the timing and necessity of the move itself; the second on its cascading impact on small investors.
Mehta is one of the many industry experts who believe that the move itself wasn’t prudent, and there was no need for the regulator to change TER Limits at this stage at all. “The industry, at an aggregate level, has not only delivered excellent returns net of expenses, but also Alpha. Pricing should be determined by the marketplace. Indian Mutual Funds, in spite of its small size in the Indian context, has the 3rd lowest cost on a comparable basis, globally”, he explains, adding that the move is tantamount to a “serious regression” for the financialization of household savings.
He continues: “Since 2000, Indians have invested more than $ 450 billion in gold - which is a transfer of household savings out of the country. Isn’t there a need to incentivise the transfer of household saving into Mutual Funds instead? We’re talking about a cost saving of 15 basis points, versus an incremental annual gain of 4-5% in returns when investors are brought into Mutual Funds”
Given that 88% of small investors still rely on intermediaries for Mutual Fund related advice, the potentially damaging long-term ripple effects of this move become painfully obvious. Venkatkrishnan sums it up succinctly, saying that if distributors find it non-viable to run their businesses, customers will end up orphaned. “There is going to be a vast advice gap as a result of this change. The affluent will be able to access Mutual Fund related advice, but retail investors will be stay unadvised”, she predicts.
What about the RIA (Registered Investment Advisor) model that the regulator has been eulogizing since 2013? Will the act of bypassing commissions altogether and charging fees directly to clients prove the silver bullet for building a viable retail business model? Most industry experts disagree.
Says Somaiyaa: “Fee based advisory for retail is a non-starter. In many cases, the fee to be paid voluntarily will end up being more than embedded commissions. If intermediaries are to reinvent or grow qualitatively, and charge a fee for advising, they are more likely to target affluent clients who are willing to pay; instead of targeting retail clients who may not be willing to pay keeping their per rupee cost in mind”
According to a source who did not wish to be named, many heavyweight RIA’s had previously been receiving “per new PAN” incentives as high as Rs. 800, cloaked as payments for investor awareness campaigns, for selling their direct plans; a practice that essentially went against the spirit of the RIA model itself. Post the new regulations, these pay-outs are likely to be suspended too, diminishing the viability of their business models even further. This begs the question: with small-ticket RIA models running into rough weather, and retail IFA’s throwing in the towel en masse, who’s going to advise the common man looking to create wealth from Mutual Funds?
The road ahead
As the time worn adage goes, “There’s many a slip between the cup and the lip”. What purportedly began as a move to rationalise AMC profit margins in the interest of retail investors seems to have transmogrified into a step towards curtailing distributor commissions, while leaving AMC’s relatively unscathed! The key question here is: is this a knockout punch for retail Mutual Fund distribution in our country? If the answer is yes, we’ll soon have a burgeoning group of first time, small investors who have invested into direct plans without advice, primarily based on hearsay – or worse – short term returns gleaned off websites. Will their maiden experience with Mutual Funds be a pleasant one, one wonders? Even within existing Advisors, we’re likely to witness a scramble to make product mixes more economically viable, which means more and more front loaded, high commission, complex products that eventually work to the detriment of the end investor. A letter from FIFA to SEBI clearly states that “in our discussions with the Government on this subject, we were given to understand that the cut in TER was not a step to cut distributor commissions”. How, then, is this critical last cog in the wheel being allowed to go unchecked, with the hit being passed to distributors almost in toto by larger players? If a mass exodus from retail distribution ensues, will it not stymie the growth of the industry as a whole? Moreover, is the 15-basis point cost saving for 2 Crore investors worth depriving millions of others of a conflict-free, advisory-led, service oriented Mutual Fund investment experience? As the rumblings get louder, we’ll have to hope that the regulator hasn’t thrown the baby out with the bathwater here.