Give investors the choice

SEBI recently stated that asset management firms can use exit load to pay for their sales and marketing expenses. This means that investors will indirectly pay advisory fees to independent financial advisors (IFAs).

This decision does not really hurt investors, as exit loads are only applicable for those who redeem units within a certain period. Nevertheless, the decision is significant as it indicates that the advisor-fee model introduced in August 2009 has not been successful.

This article shows the reason for and the impact of investors' attitude to advisor fees. It suggests how a meaningful structure can be offered that is beneficial to all.

Hidden fees

Mutual funds typically deducted 2 per cent as entry load from an investment and use it to pay commission to the IFAs. Investors were mostly oblivious to the fact that they were paying commission.

Since August 2009, however, this incentive has been removed. The current structure requires IFAs to charge fees separately for services provided.

But this advisor-fee model has not been successful for two reasons. One, investors do not want to pay fees for services they believed was free; an all-inclusive price typically disguises the cost of individual services.

An investor who buys Rs 50,000 worth of mutual units will not mind paying 2 per cent as in-built commission, where only Rs 49,000 is invested and Rs 1,000 is used to meet marketing expenses including commissions paid to the IFAs. But the same investor may not like paying Rs 1,000 separately to an IFA as advisor fees.

Two, some investors believe that “advisors” deserve fees for providing investment solutions, not for selling a product. For instance, an NFO of a large-cap active fund may be an attractive investment but may not be useful for an investor who already has a diversified fund. The argument is that fees would be justified only if advisors consider the investment context when they recommend products. So, what then is the optimal incentive structure?

Before we suggest a model, we thought it would be best to show how investor behaviour towards advisor fees can change the structure of MF offerings.

Consider a gold fund-of-funds. This structure may seem redundant. The reason is that funds-of-funds manager charges a fee for selecting an optimal portfolio. As all gold ETFs generate same returns, manager selection skill is not required. So why offer such a product?

IFAs do not get commissions for recommending ETFs, as investors buy such products through stock brokerage firms. But if mutual funds buy ETFs, the IFAs can hope to get trail commissions as long as the investors' stays invested in the fund.

So one reason for offering gold fund-of-funds is investors' unwillingness to separately pay advisor fees. Given this, how can MF offerings be more meaningful to investors, asset management firms and IFAs?

We believe that asset management firms should offer two structures on each fund — no-load and load. A no-load fund is one that discerning investors can buy directly from the asset management firm without the entry load. A load-fund with same portfolio composition would be one that the investors would buy through the IFAs. The asset management firms can utilise the entry load charged on the investments to pay commissions to the IFAs. Such practice should be disclosed to the investors.

Conclusion

The advisor-fee model will work well if there is a change in investor mindset and the way intermediaries operate. Till then, it would be optimal if SEBI introduces load and no-load funds to ensure that everyone is meaningfully served. For one, mutual funds can provide incentives to IFAs to “sell” their products. And the investors who use the IFAs would not feel the pain of paying advisor fees because of all-inclusive pricing. For another, discerning investors can buy from the asset management firms.

The regulator would have, therefore, served its objectives in helping the investors, the asset management firms and the intermediaries.

(The author is the founder of Navera Consulting. He can be reached at >enhancek@gmail.com)

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