7th June 2012

We live in an era in our country where things move forward only when they are "politically acceptable". What is true for the Central Government is perhaps true even at the level of SEBI's regulations for the MF industry. While SEBI is searching for solutions to unshackle the MF industry, it needs solutions that are politically acceptable - which will not rub the various stakeholders the wrong way. How can it allow distribution commissions to be enhanced without being seen as anti-investor? How can it permit any leeway on commissions without being seen to be tackling churn firmly? We give below our thoughts on "politically acceptable" solutions to increase expense ratios and to increase distributor commissions and thus breathe a little more life into this business.

A lot of debate has taken place on how to enhance distributor remuneration to make MF distribution an attractive business proposition. SEBI has conducted at least 13 rounds of meetings with various stakeholders to get various inputs on this issue as well as the wider issue of how to make mutual funds more relevant in the lives of average Indian savers.

It appears, from what we hear, that the current thinking at SEBI seems to be running along the following lines on the subject of distributor commissions :

1. SEBI continues to be unhappy with upfront commissions being paid by AMCs. It might want to take away the partial flexibility it has given on utilisation of exit loads towards marketing costs, in a bid to close one of the main sources of upfront commissions. All exit loads may therefore have to be credited back to the scheme - which limits the ability of an AMC to pay out upfront commissions.

2. SEBI appears willing to hear suggestions on rationalisation of expense ratios to give some more elbow room to AMCs to pay out higher commissions. It however is wary of any such move being perceived as anti-investor and is therefore keen on examining a "give-and-take" approach.

3. SEBI appears willing to hear inputs on alternative charging mechanisms for advisors to collect their fees from clients (whether through a two cheque system or variable entry load), but without compromising the right of an investor to choose how much he wants to pay his advisor.

Increasing expense ratio is not so easy

There are a number of ideas that are being tossed around on increasing expense ratios. This is frankly a very sensitive issue, given SEBI's strident posture of investor protection as its paramount objective and costs being perceived by it as a key area where it needs to accord this protection. So, how do you give some more elbow room on expense ratios without upsetting the current stance on costs?

There is a view that the expense ratio slabs be increased by 25 bps each - which means that instead of the current 4 slabs of 2.50%. 2.25%, 2% and 1.75%, the 4 proposed slabs will be 2.75%, 2.5%, 2.25% and 2%. The problem with this approach is that it can be perceived as anti-investor as the expense ratios are actually going up and the headline number - which is what the media will focus on - will now read as 2.75%. Is this going to be politically acceptable? Probably not.

The other proposal is that AMCs be allowed an additional 25 bps expense ratio for business done in smaller towns. This will in turn enable them to increase payouts to distributors in smaller towns. There are again a number of challenges in this proposal. Retail distributors in large towns can be aggrieved - are their retail penetration efforts in larger cities less important than the efforts of distributors in smaller towns? Can we realistically say that mutual funds penetration in the top 20 cities has reached saturation point? Another angle to this is what investor activists can come up with - why should an investor from one of the top 20 cities subsidise an investor from a smaller town? After all, the weighted average expense ratio of this formula will be applied uniformly across all investors. One can visualise a fair amount of debate if this proposal were to be accepted by SEBI.

A politically acceptable solution

What we need is a politically acceptable solution - one that SEBI can easily justify and defend, and which at the same time gives the much needed additional elbow room to AMCs. This is what we humbly submit as a potential solution :

The current 4 slab system was introduced in 1993, along with the rest of the MF regulations, when SEBI came into being. The current 4 slab system is as follows :

First 100 cr of AuM   »   2.50%

Next 300 cr of AuM  »   2.25%

Next 300 cr of AuM  »   2.00%

Balance AuM above 700 cr  »   1.75%

The trouble with this structure is that the absolute amounts of 100 cr and 300 cr slabs have been hardcoded into regulations back in 1993. Its now 19 years since these amounts were initially conceived as appropriate for the 4 slabs. There is a justifiable case for the absolute amounts to be reviewed - in light of inflation over the last 19 years.

If you look at the Government's own cost inflation index - the index that CBDT uses for computing capital gains, the cost inflation index for 1993-94 was 244 and the same index for 2011-12 has been pegged by the Government at 785. For all computations that the Government itself uses, it accepts that costs have gone up by a factor of 3.21 times (785 / 244) over this 18 year period.

If you apply the same escalation factor to the AuM slabs that were originally hardcoded in 1993, a very reasonable and justifiable new slab system will be as follows :

First 300 cr of AuM  »   2.50% (100*3.21 = 321; rounded off to 300)

Next 1000 cr of AuM  »   2.25% (300 *3.21 = 965; rounded off to 1000)

Next 1000 cr of AuM  »   2.00%

Balance AuM above 2300 cr  »   1.75%

As a policy, SEBI should adopt a mechanism where it reviews these absolute amounts for each slab every 3 years and make adjustments based on published Government cost inflation indices. This will ensure that over time, this system and the absolute amounts for each slab continue to remain relevant.

The important thing here - which is what perhaps makes this more politically acceptable - is that we are not proposing any increase in expense ratios at all. All that we are proposing is to apply cost inflation indexing to the amounts that were hardcoded way back in 1993 for each slab and which have lost all relevance over the last 19 years.

Implications of this proposal

Effective expense ratios that funds can charge will be as follows under our proposal :

The effective increase in expense ratios - or the incremental elbow room - will vary between 15 bps and 30 bps - depending on the size of assets of each scheme, if our proposal is accepted. There are around 349 equity schemes (including ELSS) which have a cumulative AuM of around Rs. 179,620 crs (AMFI data : April 2012), which works out to an average scheme size of Rs. 514 crs. However, like in everything else, the 80-20 principle works in this average too. 80% of the industry's equity assets - which is where bulk of the flows come in today - is focused on the top 80 schemes out of these 349 schemes. In this list, the largest scheme has an AuM of Rs.11,064 crores and the smallest scheme within the top 80% of industry equity AuM has a size of Rs. 589 crs. These funds - that represent 80% of assets and perhaps a larger share of actual flows - have an average size of Rs. 1984 crores. Purely in terms of flows therefore, there would be an incremental elbow room of somewhere between 28 - 30 bps under this proposal. And for schemes that are in the Rs. 500 crore range - there is a clear cut incentive to focus on increasing scale to get to the 1000 crore mark - where the incremental benefit increases from 15 bps to 28 bps - rather than promoting more NFOs. SEBI is anyway keen on AMCs having a smaller product basket and promoting each fund to scale - so this proposal may make sense from that point of view too.

With this proposal, one can actually achieve more than the 25 bps that AMFI is seeking, without actually increasing the expense ratios at all! As the old Hindi saying goes " Saap bhi mar jaye aur laathi bhi na toote" !

Implications for distributors

An incremental 25-30 bps in the form of higher expense ratios can be passed on by way of higher commissions to distributors. Distributors who were getting 0.5% trail can hope for something between 0.75% - 0.80% as trail for all years, while the bigger distributors who are currently at an average of 0.75% trail can now hope to hit that magic number of 1% trail for all years.

While all of this sounds good, what if some large distributors try to squeeze additional upfront commissions from such an increase in expense ratios? We know very well SEBI's dim view on churn induced by high upfront commissions. For our proposal to be truly politically acceptable, we then have to cover off one more angle - how can the industry give comfort to SEBI that it will be in a position to control churn if expense ratios are effectively enhanced through this proposal?

Tackling churn

Many advisors have argued in our forum that the ban on entry load was too sweeping a change that SEBI introduced in order to check churn. A more caliberated approach - where only the guilty are punished - is what was perhaps called for. In the same tenor, there is an apprehension that a complete and sweeping ban on upfront commissions can cause further damage than cure - especially in the retail segment.

The fact is churn continues almost 3 years after entry loads were banned. Investors have not really been protected from this menace as yet. We have consistently argued that as long as there is a wide differential between the commissions earned in the first year and in subsequent years, you are always creating a desire to churn, among those distributors who wish to continue churning.

We have consistently argued in our columns that persistency data on average assets for each distributor can easily be made available at an industry level. We have also called for this (rather than absolute commissions paid) to be made public. Lets take this one step further.

Industry average age for equity assets is around 2.5 years - somewhere around 900 days. This average is made up of a combination of a few large distributors whose average is around 400 - 500 days and several small and large distributors whose average is well over 1000 days. In our view, AMFI should prescribe a minimum acceptable persistency of equity assets - in the form of average number of days - at an industry level - which will be applied for all distributors - large or small. For example, AMFI could take a view that the minimum acceptable persistency should be say 2 years - or 730 days.

Any distributor - however large or small - whose average age of equity assets is less than this norm (of say 730 days), should not be entitled to receive any upfront commission of whatever nature. All AMCs must pay exactly the same trail for year 1, year 2 and year 3 for such distributors. What we mean by this is that while each AMC may decide how much trail they wish to pay, whatever they decide to pay must be the same for years 1, 2 and 3. Once commissions are the same for years 1, 2 and 3, the commercial urge to churn is automatically taken away. That should help bring down churn - among those who actually churn.

As regards all other distributors whose persistency is above the minimum prescribed, well there is no need for the regulator to become Big Brother - they are not misbehaving, are they? You can allow market forces to work normally in this segment. Let the AMCs and distributors decide what works best for them. Some distributors may prefer higher upfronts and lower trails while others may prefer it the other way around. Lets just leave that to commercial negotiations between the two parties.

The need is to identify and isolate the few distributors who are causing grief to the industry and the regulator and come up with a differential remuneration system for them that takes away the incentive to churn. There is no need to do another sweeping regulation that impacts all - in the bid to police a few.

In conclusion...

What we have proposed is what we believe is a politically acceptable way of allowing higher expense ratios without actually increasing the expense ratios. But, it will become truly politically acceptable only when SEBI gets comfort that the increase in expense ratios will not further induce churn. Rather than indulging in a "give-and-take", where SEBI gives some room on expense ratios but takes away the right of AMCs to decide commission structures by imposing a blanket ban on upfront commissions, we submit that AMFI proactively decide and implement an anti-churn policy along the lines of what we have recommended. Its only when AMFI actually implements such an anti-churn policy, that SEBI can be expected to let go of its concerns on upfront commissions and for it to allow market forces to operate normally in the large segment of the market that is not behaving in an anti-investor manner.

What do you think of our proposal on expense ratios? What do you think of our proposed anti-churn policy? Do these make sense? Are they practical? Will these measures help business to be run in a more viable manner - by distributors as well as AMCs? Share your thoughts will advisors across the country by posting your comments in the box below - its YOUR forum !