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In the recent AMFI AGM held last week, one important decision that was taken - and must now be implemented by all AMCs - pertains to clawback of upfront commissions for premature redemptions. For a long time, Wealth Forum has been arguing the case for an effective anti-churn policy that AMFI must enforce on all AMCs . AMFI has now decided that a transaction level commission clawback is the best way to deter churn - which continues to be a big issue for the industry.
Get ready to see debits in your commission income statements
Effective October 2012, while AMCs will be free to pay upfront commissions on equity and debt funds, they must institute a clawback clause that allows them to take back a proportionate amount of the upfront commission paid to you, should the investment be redeemed prematurely. For debt schemes, premature will effectively mean within the exit load period. If for example, you received a 0.5% upfront on a client's investment in a short term debt fund where there is an exit load for redemptions within 6 months, and the investor redeems at the end of month 3, half of your upfront commission will be clawed back by the AMC. On equity funds, clawbacks are expected for redemptions within a year, even if exit load periods are for longer periods of 18 months to 2 years. So, if an investor redeems within 6 months from an equity fund where the exit load period is for 18 months, you would anyway stand to lose half of your upfront commission, as the investor redeemed 6 months earlier than the minimum 12 month window for the clawback. It will not be linked to a longer exit load window - which could have meant higher clawbacks.
Distributors will now pay a direct price of quick redemptions done by their clients - either for profit booking or any other motives. You will now need to scrutinise your commission income statements even more closely - and see what kind of debits are hitting you for redemptions done by your clients. Distributors are already familiar with clawbacks in long term MF SIPs as well as in insurance products - now, the world of clawbacks comes into all mutual fund transactions as well.
Those distributors who do "deals" where upfront commissions are partially passed back to clients, will run an even bigger financial risk, should these clients exit the schemes prematurely.
Some of the large fund houses seem to be considering paying out upfront commissions in the form of EMIs - equated monthly instalments - to get around the need to clawback commissions. The EMI will get stopped the moment a redemption is triggered - thus, the need to take back commission already given does not arise. Some fund houses are looking at offering upfront commissions for transactions below a certain limit - say Rs. 10 lakhs. Transactions above that amount will be paid only through trail fees. The worry that most fund houses have is about implementing clawbacks - they have to deal with either a credit issue (where the clawback may be larger than the next month's payout) or a relationship issue (where resentment builds for distributors who see clawbacks for redemptions done solely by the client - without any such advice by the distributor). Implementing clawbacks is going to be quite a challenge for the industry.
Exit load policies are changing in tandem
Some AMCs are proactively changing their exit load policies, in a bid to make quick exits less attractive for investors - and thus hopefully prevent a clawback situation from arising. ICICI Prudential and Axis have already announced revised exit load policies - and others will undoubtedly follow shortly. ICICI Prudential now has - for its equity funds - an exit load of 3% for redemptions within 6 months, 2% for redemptions between 6 - 18 months and no exit load for over 18 months holdings. Exit loads collected henceforth will be credited into the scheme - thus ensuring that long term investors get the benefit of penalties levied on short term investors. The twin approach of upfront commission clawbacks and stiffer exit load policies is expected to help deal decisively with churn - which continues to be one of the biggest challenges that the fund industry faces.
Here is what Aashish Somaiyaa, Head of Retail Business - ICICI Prudential AMC has to say about why I Pru has changed its exit load structures :
1. "Given that exit loads are no longer available for marketing expenses, we can now use exit loads purely as deterrent against distributors who churn assets or investors who trade in equity funds. Hence, we have now increased exit loads in select equity schemes upto 18 months. This will increase persistency of the equity assets and it enables us to pay little more commission to our performing partners. It does not harm investors' interest because we all appreciate that benefits of equity investing with compounding of capital accrue over longer holding periods. Short term trading is purely incidental but not sustainable.
2. The increase in exit load will also ensure that in an era where all upfront will be paid with clawbacks, as a responsible partner, we need to put some safeguard in the product, whereby instances of clawbacks are minimized. If we continue to have low or no loads with zero capital gains tax, by all means churning or trading will occur and clawbacks will get triggered. The exit load will be an effective deterrent."
ICICI Prudential is changing its exit loads for schemes like its Discovery and Dynamic Funds - which it strongly advocates should be held through a market cycle. Funds like its Focused Bluechip are not in the ambit of this change. In a sideways market, there are investors who time the market rather than staying invested for the long haul - and typically prefer large cap oriented products as their vehicles. There is less merit in imposing a higher exit load in such products - which do see some "hot money" coming in and out from time to time.
How would you like your commission, sir?
AMCs are now likely to offer you a wider set of commission structures - and give you the option of selecting a remuneration model that best suits your business. You could have a high upfront (with clawback) and low trail model at one end and a full trail model at the other end of the spectrum, with a few options thrown in between to complete the range. You will now have to consider what works best for you. If upfront commissions are vital for your business model and you are confident of mobilising long term assets, you can go for a high upfront and low trail model. If you are an established player with sizeable AuM under your belt, you may find a full trail model working better for you. While the commission structures will be announced in the coming weeks, an educated guess is that for full trail models, you could perhaps expect anywhere between 1% to 1.50% p.a. as trail - from year 1 to perpetuity - for equity funds where the TER is likely to be around 2.5%. Where within this 1% to 1.5% you fit in, will obviously depend on your business volumes with individual AMCs. Internationally, distributors typically get anywhere between 40% to sometimes as high as 60% of the TER as their annual trail from AMCs.
If you are an established and experienced IFA, and were to now be offered say 1.25% p.a. as perpetual trail and zero as upfront, would you bite? My guess is, yes.
Are your commissions likely to increase?
It appears that distributors who chose a full trail model can end up earning significantly higher than what they earn presently - provided they have a sizeable existing book that gets repriced and provided they have high persistency of assets. Distributors who prefer high upfront commissions may not see a significant increase in commission rates - unless you happen to be in the cities outside the top 15 - where you could perhaps see a 0.5% to 0.75% higher upfront than what you were previously getting. Commission structures will settle down in the coming months - and what we hear now is the initial thoughts of some of the leading fund houses. Again, an educated guess is that there will probably be two sets of distributors who might eventually gain, once the commission structures settle down : those who are in smaller cities and those who opt for a full trail model. Distributors who opt for a full trail model will gain in the long term, although their income in year 1 may be lower than what they currently get through a combination of upfront and trail.
How will the big boys be impacted?
It is often said that large banks are the biggest churners of mutual funds. How will the clawback impact their sales practices? Quite deeply, I guess. Large banks already have clawback arrangements in place for insurance distribution - as most insurers have clawback clauses already in place. These clawbacks directly impact the branch and the sales person concerned. It should not therefore be difficult for the large institutions to pull together a system that does likewise for mutual funds as well. A clawback that directly reduces the RM's incentives, coupled with the new SEBI regulation of pinpointing and recording sales persons responsible for every MF transaction - will go a long way in making an RM think twice before getting trigger happy with a client's portfolio.
How will this impact active advice models?
There are a few HNI oriented advisors and private wealth managers who strongly believe in active advice - in getting clients into and out of themes that they believe will have market momentum. Their business model does not revolve around churn for the sake of higher commissions, but in making quick decisions on sectors and themes in a bid to deliver additional alpha to their clients. I suspect these players will perhaps opt for a full trail model as their upfront commissions are likely to be vulnerable to clawbacks getting triggered, should they change their stance on the market.
To conclude
The MF industry has made its first serious attempt at tackling churn, by making it mandatory for all AMCs who pay out upfront commissions, to institute a clawback mechanism. There will undoubtedly be a lot of learnings from this new exercise, and perhaps many refinements in the process that will happen from these learnings. The intention is clearly in the right direction. What do you think of the clawback mechanism? Will this deter churn? Is this a step in the right direction? Do you foresee any practical issues with implementation of clawbacks that you would like to bring to the industry's attention? What kind of a commission model will you prefer - an upfront with clawback and normal trail or a full trail model with no upfront commissions? Share your thoughts with the industry by posting your comments in the box below - its YOUR forum !
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