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The Either-or Situation

Although well-intentioned, Sebi’s proposed investment adviser regulations have complex ramifications for the mutual fund distribution business. Here’s why

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There is an amusing comic strip doing the rounds these days. An allusion to the Securities and Exchange Board of India’s (Sebi) ongoing efforts towards separating mutual fund “advisory” from “distribution”, it goes like this: an investor with a small bag of cash approaches a distributor with the simple question: “Which is the best fund for me to invest in?”, to which the distributor responds with a curt “Sorry, I can’t tell you that”. Disappointed, the investor then makes his way to the office of a financial advisor, and repeats the same question. To which, the advisor’s response is, “Well, I can tell you that — but I can’t sell you that”.

A Peculiar Choice
Indeed, investors in the burgeoning Rs 22.41 trillion assets under management (AUM) mutual fund space will soon face a peculiar quandary. As if the question of ‘where to invest’ wasn’t a difficult enough one to wrestle with, they will soon need to decide ‘how to invest’! If Sebi’s latest proposed norms were to fructify, the existing distributors will need to firmly decide which side of the fence they belong to – selling, or advising.

If they choose the former, they will be disallowed from making investment recommendations. If they choose the latter, they won’t be permitted to sell a mutual fund scheme in any form or shape, either by themselves or through an immediate relative. Violations, if any, will purportedly invite penalties of gargantuan proportions!

When it comes to Sebi’s investment adviser norms, three key questions beg consideration. First, are the regulations practicable or will they just prove nugatory as industry players find creative workarounds? Second, will they benefit the industry as a whole; be it through the cleaning up of advice, or by driving more financial savings into higher growth assets than bank deposits and traditional life insurance? Third, and most important — will it add value to investors?

Industry experts such as Sudip Bandyopadhyay, Group Chairman, Inditrade Capital, have lauded the regulator’s intent behind the investment adviser regulations. They believe it is a step towards increased transparency and the cessation of commission-motivated selling. However, a growing number of them now believe that if the regulations are formally implemented, it would result in a mass exodus from even the handful of RIAs (registered investment advisers) who have procured licenses so far.

“Most RIAs-cum-distributors would prefer to go ahead as distributors only, and may not renew their RIA licenses,” says Bandyopadhyay. “The mutual fund business is yet to move from a commission-based business to a fee-based business. RIA licenses enabled many distributors to build trust with their clients; but considering the only workable revenue model which is still commission centric, most RIAs-cum-distributors may prefer to stay back as distributors only,” he adds.

Bengaluru-based is one such RIA-cum-distributor that manages over Rs 300 crore of mutual fund assets. Prateek Mehta, its co-founder and CEO supports Bandyopadhyay’s view. He says that if the regulations do get implemented in their present form, “many advisors might relinquish their advisor tag and just become distributors”. Financial advisors often provide advisory around liabilities, taxes, forex, real estate, insurance, PMS-es and AIFs. “It is currently unclear if Sebi wants RIAs to have zero distribution income from sources other than mutual funds as well,” says Mehta.

It’s worth noting that only 846 (as of 14 February)intermediaries out of the 80,000-plus community of mutual fund distributors have gone ahead and procured RIA licenses in the past five years, and that’s barely 1 per cent of active intermediaries.

The regulator’s efforts towards establishing a fiduciary relationship between those who distribute mutual funds — and those who invest into them — have been under way for some time now. In fact, half a decade has lapsed since Sebi had first rolled out its investment adviser regulations in 2013. Regrettably, the most recent paper only served to befuddle the issue further — particularly, the point that relates to “whether or not mutual fund distributors (MFDs), while distributing their mutual fund products, should be allowed to explain the features of products to the client, and ensure the principle of ‘appropriateness’ of products to the client”. After all, where exactly does “ensuring appropriateness” end, and “advising” commence?

“What we actually need is ‘share classes’ — that is, different pricing plans depending upon the size of one’s investment, and basis whether an investor wants to buy direct plans and pay for advice, or pay with commission embedded in the total expense ratio (TER). The current regime does not allow this and that’s a serious anomaly,” says Aashish Somaiyaa, CEO, Motilal Oswal AMC.

Somaiyaa, for one, believes that the fear of commission-motivated selling in the mutual fund business is heavily exaggerated. “The difference in commission pay-outs between different funds is in range of just 0.1  to 0.3 per cent per annum. This just isn’t enough motive for anyone to go out of their way to sell a wrong product!” he says.

Accidental Experts
Throw in Direct Plans, and you add another layer of complexity to the mix. It’s a well-known fact that bullish markets breed many an ‘expert’. Barring a brief, range-bound phase in 2012-13, Indian equities have pretty much been at a canter for six years running; with the bellwether Nifty index having more than doubled from its sub-5000 levels back then. Parallelly, bond markets registered stellar growth between 2014 and 2017, as 10-year G-Sec yields plummeted from 9 per cent levels all the way down to 6.25 per cent. Undoubtedly, this impressive market growth fuelled the self-confidence of many an investor, driving them towards direct plans of mutual funds in which they saved between 0.50 to 0.75 per cent per annum in the form of unpaid commissions.

Many of these self-advising experts were dealt a rude shock last year, when their debt mutual funds grew by just 0-3 per cent. With a lot of the tailwinds (low inflation, low crude prices, global weakness) that drove both domestic equity and debt market growth in the past five years starting to taper off now, we are quite likely to witness a significant proportion of this self-assurance giving way to self-doubt over the next few years, as securities prices revert to their means. It is also a disturbing fact that a whole lot of investor money that was really intended for fixed income investing, has found its way into high-risk equity-oriented funds in the past two years, via direct plans. Mercurial markets will soon have a lot of these investors wringing their hands in agitation.

“The approach of trying to go direct and save costs could lead to long term implications on risks to the net worth of investors, and is best avoided. It would be wise for the regulator to consider that only sophisticated and accredited investors that have an investable worth of over Rs 5 crore, or institutional investors that have an in-house treasury or an investment teams, should be given access to direct plans,” says Sanjay Sachdev, Chairman of ZyFin Holdings. Sachdev adds that the regulator should focus on building skill-sets and qualifications of advisors, while nudging investors to take their professional advice to reach their investment goals.  

Defeating The Original Purpose?

There’s a theory doing the rounds that the implementation of investment adviser regulations in their current form will, quite ironically, end up defeating its original intended purpose of enriching the experience of retail investors and migrating mutual funds away from being a rich man’s prerogative. Indeed, there is substantial weight to this argument.

Consider, for a moment, a retail investor with an investment of Rs 5 lakh in regular plans of mutual funds. This investor would be bearing an indirect cost of roughly Rs 5,000 to Rs 7,500 per annum in the form of commissions paid, depending upon his portfolio mix. In exchange, the investor most likely receives at least a basic level of investment advice from his distributor.

Once the new rules kick in, this distributor would be disallowed from dispensing ‘advice’ to the client, and will have to restrict the scope of their engagement to execution services only – leaving the client with three choices: continue to ‘execute’ through the distributor while doing his own research, terminate his engagement with his distributor and invest, fully unadvised and unassisted, into direct plans of mutual funds; or seek out the services of one of the 840-odd Sebi registered investment advisers in exchange of a fee.

But here’s where the disadvantageous paradox lies. It’s been widely predicted that RIAs will not show much interest in serving this investor segment at all! Most pure fee-based advisers in India haven’t been able to command anything more than 0.5-0.7 per cent of assets as annual fees. Continuing from the previous example – will Rs 2,500 per annum justify an RIA’s cost of conducting quarterly meetings and portfolio reviews, providing regular updates, writing financial plans, and providing a host of other services to this client? Probably not, unless they all magically transmogrify their business models into low cost, “non-brick-and-mortar” styles of engagement!

So, we are quite likely to have a situation where most RIAs peddle their wares exclusively to high net worth clients who won’t cringe while writing cheques of Rs 30,000 to Rs 50,000 every year; leaving the throngs of retail investors with the twin options of either investing through distributors who aren’t “allowed” to advise, or hazardously investing on their own, into direct plans.

Mehta of predicts that retail investors who choose to go ahead unadvised, will suffer the most in the long run. Bandyopadhyay believes that both investors and the industry may suffer in the short run. Somaiyaa points out that research has shown that investors usually don’t mind incurring investment-related costs, provided they are embedded into the product; but if you reduce embedded costs and ask them to pay separately for advice, they may give it a wide berth. “There is resistance to pay for advice”, he says.

What Next?
As the pressure to bring matters to a final conclusion mounts, the forward-thinking regulator is faced with a series of complex choices. It will have to find a way to accomplish its objective of cleaning up commission-centric advice, while leaving the retail investor community and the mutual fund industry unscathed. Controlling pricing artificially by focusing excessively on moderating TERs will have long-term negative repercussions on the industry as a whole. Perhaps, the optimal solution does indeed lie in letting both models co-exist within a business, while leaving the choice of modus operandi to the client?  As Somaiyaa rightly points out, is the paltry difference between fund commissions really enough for distributors to “tailor-make advice” in conflict with the long-term interests of their clients? The industry will have to wait and see how Sebi walks the tightrope.

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Magazine 3 March 2018 personal finance insurance sebi