“Sunshine is the best disinfectant” – said someone. I came across this phrase for the first time while reading an interview of the then SEBI Chairman, Damodaran.
As we know, SEBI was established in 1988 but got regulatory powers in 1992. The baton was handed over from CCI (Controller of Capital Issues) to SEBI. This ushered in a big change at the policy level. CCI was a controller, as the name suggests. This meant that they controlled the issue size and issue price in case of IPOs. It was a shift from control-based regime to disclosure-based regime.
These days, disclosure has become the buzzword in the mutual fund distribution business. We are referring to the recent circular on commission disclosure.
The quote we started with seems to reflect SEBI mandate and approach very appropriately. However, if we take the analogy further, the meaning gets changed.
While sunshine might be the best disinfectant, it has to be in moderation. Too much of it may be harmful – in fact, too much sunshine causes skin burns and eye problems.
Trees provide shade – a protection against too much sun. They block the sun. Does it mean that trees are bad? If that was not enough, we invented sunglasses and sunscreen lotions. What is required is enough sunshine to work as an effective disinfectant but not so much that it burns the skin.
So let us come to the recent circular regarding commission disclosure. Is it bad? Is it incorrect? Is it inappropriate? Is it ahead of time? There are many questions. What is the answer to these questions? These can be debated. However, let us go to the basic objective of some of these changes.
In the aftermath of 2008-09 global meltdown, regulators started discussions about mis-selling of financial products by various intermediaries the world over. The regulators became active in bringing out new regulations. The objective of these regulations was to ensure protection of investor interest and to safeguard the investor from mis-selling.
This is where the original move of SEBI (the 2009 regulation about commission disclosure by distributors) was to disclose commissions of all competing products along with the recommended products. That would give the client an idea whose benefit was served by the products recommended. The current regulation is silent about competing products but only focuses on what the distributor earns. That has some unintended consequences.
Let us have a look at some of these unintended consequences:
- Commission disclosure along with direct plans is a deadly combination:
Discounting is not allowed by mutual fund distributors, which means that the gap between “regular” and “direct” plans would be decided by the asset management companies. The distributor cannot decide what his services are worth, since passback (the distributor giving back some part of the commission to the investor is not allowed as per the SEBI regulations) is not allowed. This puts the distributor in a very difficult situation as the same mutual fund scheme is available for two different prices and the gap is explicitly disclosed. The only choices the investors have are (1) invest through a distributor at higher cost or (2) invest in direct plan at low cost. The choice seems obvious.
This has the potential to hijack the conversations between the client and the distributor. Instead of discussing the value that a distributor provides (which is not only in the returns earned on the recommendations – distributors provide many services, conveniences, comforts and advice), the discussions would be about justification of the difference. The poor distributor is helpless since one cannot lower the gap between a direct and a regular plan, since passbacks are not allowed.
Am I in favor of passbacks? Am I recommending that passbacks should be allowed? Well, I have a different take on that. When the Government of India wants to divest its holding in PSUs, the retail investors are offered a discount. A couple of years ago, they divested some of the PSU holdings through an ETF called CPSE ETF. In this case, the retail investors were offered a discount at the time of NFO and those who stayed invested for a year, were allotted bonus units. Is this not a passback? But when the Government does it, nobody questions. If a small distributor were to do it, the poor guy would lose the license to work. In other terms, the poor guy loses the livelihood.
Is this fair?
- Many distributors are shifting to products like PMS and AIF. These are “non-transparent” or “less transparent” compared to mutual funds.
Many of these products are also less liquid and have higher expenses.
Is it serving any interest of the investor?
- Some investors would opt for the direct plan, as it is “cheaper”
A direct plan may be suitable for (1) savvy investors, who have enough time and money as well as skill set to understand how to manage investments, or (2) those who seek advice from investment advisors and financial planners, who offer advice by charging fees.
In my experience, some of the investors opting for direct plan may qualify for either of the above two but majority don’t. Even after choosing the direct plan, they seek “free” advice from someone or anyone. They typically go to media, experts appearing in TV shows or writing in media or their friends, who appear to be financially savvy. While I won’t comment on the expertise of these people, in most cases, they do not have enough time (since they are not compensated at all) to analyze the situation of the investor and offer “suitable” or “appropriate” recommendations. This goes directly against SEBI regulation on mis-selling in mutual funds. [For details, please refer to the relevant SEBI circular issued through Gazette Notification dated December 11, 2012. This was issued as part of Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to securities market) (Amendment) Regulations, 2012].
The other place where they seek advice is the AMC offices.
However, one must understand the economics of this.
Can a mutual fund company employ people who could be as good as some of the seasoned distributors? They may get education but from where do they get the experience? This argument should be seen in the light of the fact that the money available to pay the salary is “zero” – theoretically. The AMC employees cannot sell funds of other mutual fund companies. This means the recommendations would be biased only in favour of their own AMC. This also goes against the interest of the investor.
One can go on and on as there could be many more unintended consequences. I have highlighted four –
(1) A possibility of the distributor-investor discussion getting “penny wise, pound foolish”,
(2) Violation of principle of natural justice – a regulation applies to the industry but the Government is exempt from that;
(3) Contradicting an existing regulation that was brought in for the protection of interest of the investor, and
(4) A very distinct possibility that can go against the interest of the investor.
Very often, the intent is right and fair but there could be some unintended consequences that must be considered.
The author runs Karmayog Knowledge Academy. He can be reached at amit@karmayog-knowledge.com. Recently, he has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”.
