SEBI bans upfront commissions to Mutual Fund distributors

Honesty is a very expensive gift. Don’t expect it from cheap people.

Warren Buffet

Last month SEBI asked Mutual Fund Asset Management companies (AMCs) to stop paying upfront commissions to distributors and instead adopt a full trail model of commission in all their schemes. This is a very admirable move by SEBI, to the large discomfort of a lot of distributors who had made a practice of earning extra income by churning their client’s portfolios frequently. Such upfront commissions were in the range of 1 to 1.5 percent and hence very lucrative to distributors. Each churn earned them an upfront commission from the AMC at the cost of the beleaguered client who was left to wonder why her MF investments were not delivering the expected returns.

This move by SEBI is the latest in a series of moves by the regulator in order to bring greater transparency to the Indian Mutual Fund industry for the benefit of retail investors. Some of these include:

• Removal of entry loads in all schemes of all funds
• Introduction of Direct plans in all schemes of all funds
• Capping of maximum Total expense Ratios
• Tapering of Total Expense Ratios by Assets under Management
• Mandatory disclosure of expense ratios by mutual funds for all schemes
• Mandatory disclosure of any and all changes in expense ratios to existing investors
• Standardization in the naming of mutual fund schemes to prevent confusion
• Mandating fund houses to use TRI (Total Return Index) v/s PRI (Price Return Index) for benchmarking performance of funds
• Introduction of the ‘riskometer’ – a five point scale from low to high – to enable investors better understand the risk associated with the fund.

The point of all this is to understand that the regulator is taking proactive steps and making changes to the investing framework to protect the interests of the small investor. Yet none of it will succeed if investors themselves choose to remain uninformed or uneducated about the benefit of these moves. Many a mutual fund investor has become so used to the prevailing system of investing via mutual fund distributors that they are averse to take advantage of the new framework even when it is in their own interest.

What to do

The simplest thing to do is to switch over from regular plans to direct plans of the same fund. The difference in expense ratio between a regular fund and a direct fund of the same scheme can be up to 1.0%, and when this difference is compounded say over the next 10 years, it can mean an additional return of more than 9%! In other words, if you have Rs 10 lakhs invested in a regular plan today, you can earn an additional 208,000 over the next 10 years just by moving to the Direct plan now (assuming a 8% return on the fund in the regular plan).

But hold on, just making a blind switch is not in your best interest, if only because it will lock you in for the next one year (remember exit loads). So if you are convinced about the need to make the switch you will be better off contacting a SEBI RIA to go over your financial plan and link your investment plan to your financial goals. Working in your best interest, your advisor will also recommend the best funds appropriate for your level of risk tolerance. And then suggest you to make the switch in a structured and tax efficient manner.