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The Canadian market regulator (CSA) has published a discussion draft earlier this month, where it suggests that trail commissions are anti-investor and that the best way forward for Canada is to move away from embedded commissions and have a direct pay mode, where investors pay an agreed fee to the advisor directly.
India and Canada are seen as the two highest cost MF markets
We know that the Indian regulator tracks developments in Canada quite closely since both Canada and India are perceived to have the highest cost structures for mutual funds in the world. This has been strenuously contested by Canada's trade body IFIC and by India's IFA body FIFA in their respective research papers. However, mainstream media in both countries continue to harbour the notion that costs are high, which has prompted regulatory intervention time and again in both countries around costs. The latest salvo from the Canadian regulator will in a sense be seen by SEBI as validation of sorts on its own efforts to take out distribution costs from MF expense ratios, by pushing for the fee based RIA model.
Lots for us to learn from the Canadian consultative process
Having gone through the very exhaustive discussion paper, I must say I have come away impressed with the manner in which the regulator constructs their case and puts it forward to the industry for views. One may agree or disagree with the conclusions, but one must say that their regulator is very transparent in disclosing their mind - which is in stark contrast to SEBI's stated position that it is reluctant to disclose "the mind of the regulator" as it stated in response to an RTI request by a South based IFA last year.
CSA's discussion paper's approach highlights:
What it thinks is the key issue What is the evidence that suggests that the issue is real (and not perceived) What are the options considered by the regulator, which options were dropped, which were shortlisted and why Clear recognition of the industry's position on the matter and the stated rationale for the industry's objection/reluctance towards a change Clear direction to the industry to come up with arguments, backed by research and numbers, that demonstrate that the benefits of status quo are more than the benefits of making the suggested change.
A time frame of almost 6 months has been given to the industry to present its views - which gives enough time to conduct research to independently assess both options - status quo and change. It would indeed be great if our regulator adopts this methodology for its discussions on proposed regulatory changes.
Three points on why trail is anti-investor
Now, let's come to the key finding of CSA that trail commissions are actually anti-investor. There are three key points which CSA is making:
1. Most investors don't know they pay trail and can't influence it anyway
Canada, like India, has moved substantially in recent years from a front end load model to a trail fee model. In Canada, front end loads were negotiated between investor and distributor (while in India, it was fixed and the pass back form of negotiation was officially banned though widely prevalent).
CSA says that in the days of entry load, distribution costs were very clearly known to the investor, who had an ability to negotiate and agree the amount he was willing to pay - though the payment was made by the fund house deducting it from the investment amount and paying to the distributor. Now that commissions are embedded into product costs and paid out as trail, many investors don't even know that there is an embedded commission and the few who know are anyway not in any position to influence it. Investors' sensitivity towards distribution costs has reduced over time. Not knowing that they are paying is anti investor. Not being able to influence it, if they know they are paying is also anti investor.
Canada is implementing this month, commission disclosure in account statements, which is similar to what SEBI introduced effective last October in India. But CSA says mere disclosure is not enough as it only will reduce ignorance of commissions paid - it still does not give back to the investor the right he used to have to determine what he wanted to pay to his distributor.
2. Investors cannot ensure they get service commensurate with trail paid
The second issue CSA has with trail commissions is that there is no mechanism for the investor to ensure that he gets ongoing service that is commensurate with the trail commission paid annually. CSA points out to discount brokers who sell funds with full trail commissions, even though they do not offer any ongoing advice or hand-holding. CSA points out to advice embedded products (packaged solutions that dynamically alter asset allocation either in keeping with life stages or market parameters) - which by definition do not require ongoing advice, but which are still sold with full trail commission. And then of course will be individual instances of intermediaries who earn trail but do not actually deliver the kind of ongoing advice for which this trail is paid to them. In all these cases, there is a trail commission paid for ongoing advice - which is either not required, or not delivered even if required. That is anti-investor.
3. Benefit of advice is largely behavioural and therefore product agnostic
The third issue CSA raises is that all research studies suggest that the benefits of advice are largely behavioural and not product specific. The real benefits of advice are instilling a good saving discipline, overcoming inertia, developing conviction in markets, reducing anxiety - all of which are extremely important, but are agnostic to whether the product recommended is A or B. These are all behavioural. Why then should the cost of advice be embedded into product A or product B, when in fact the advice has very little to do with selection of A vs B? Isn't it right for an investor to pay for behavioural advice separately - in a manner that works best for the advisor and investor - whether ongoing or one-time or fees by-the-hour etc?
Why Canada is not UK and should not fear retail advice gap
CSA goes on to suggest that a move from trail commissions to a fee based model will have to be facilitated by the fund industry - like it used to in the days of negotiated entry loads. Expecting investors to issue periodic cheques for advice will be difficult and will make the transition difficult.
In response to the industry's observations on the challenges that UK has faced in making the transition to a fee based model, CSA makes some interesting fact based observations on the differences between the Canadian and UK markets.
CSA showcases extensive research that proves that retail investors in Canada overwhelmingly use either banks or insurer owned distributors and it is only HNI investors who use independent advisors - quite unlike the case in the UK. The notion of retail investors being left stranded in a fee based environment is therefore not a real fear in Canada in CSA's opinion - though this has happened in the UK.
IFAs are critical in India for retail distribution: advice gap fear here is real
What is very relevant for our regulator to understand when they review CSA's paper, is that in India, the IFA performs the role of reaching out to retail investors - quite like the case in the UK. Retail advice gap has occurred in the UK after switch over to a fee based model, and it will happen here in India too, for the same reasons. CSA provides data and logic to support its case why it believes retail advice gap will not occur in Canada. We need SEBI to help us similarly understand why this fear of retail advice gap is not relevant in India - and if we can't access concrete evidence, we must acknowledge that this fear is real.
Is there some truth in CSA's 3 points on trail?
Is there some merit in CSA's observations on the downsides of trail commissions? I guess the honest answer is - yes. The fact is that many investors were not even aware of the concept of a trail commission and its quantum - which is why the recent commission disclosure regulations have caused so much discomfort among a large section of our distributors. Are investors in a position to enforce service delivery? No. For starters, we don't even have a standard set of deliverables that a distributor must offer to investors, to justify the trail/upfront commission he receives. Service levels vary widely across channels - be it banks or NDs or IFAs. So, while we may vociferously support trail commissions as investor-friendly, do we have a responsibility to ensure that we deliver service commensurate with the trail cost borne by the investor? The short answer is Yes. That's what will make trail a truly investor friendly move. Rather than empowering the investor to decide how much he wants to pay, let the discussion move to how to empower the investor to ensure he receives value for the cost he bears.
How can we ensure delivery of value for trail cost borne by investors?
We at Wealth Forum have been consistently favouring raising the standards of sales process to make every distributor accountable for the service he delivers, and make him justify the trail fee he earns. If we have to treat investors fairly, and yet consider the viability of business models, the best way forward in my view is to:
Do away with upfronts altogether Have a trail only model Enforce a sales and after sales process guideline for all ARN holders - which will be made available to investors. Investors must know what is the pre-sale and after sales service they should expect from their distributor, and must have a mechanism to hold them accountable for its delivery.
Should a distributor be accountable to perform a portfolio review at least once in 6 months for all his clients? If he simply cannot review client portfolios because client numbers are too large, how then does he justify the trail commission he receives on these small portfolios? There needs to be a debate on this and other aspects of service and advice delivery, and an agreement on a minimum SLA (Service Level Agreement) that must be ensured by every distributor. Investors should be able to hold their distributor responsible for meeting the SLA and should be able to lodge a complaint with AMFI for non performance of SLA.
Is this all coming too late?
As a market, we are not quite there in terms of ability to shift to a fee based model across all customer segments. Going by CSA's observations, the best solution will be fee based advice that focuses on behavioural aspects and transaction based mutual fund commission, decided between investor and advisor and payment facilitated by fund houses. Our market may evolve to this position - one day. But that one day is not today, nor can be seen in the immediate future.
Embedded commissions may not be the purest solution, but are clearly the most practical solution, at this juncture of our market's development. However, the points CSA makes do have an element of truth - and we must address them proactively, in investors' interests. It is best if the industry engages in a debate and agrees a self regulation driven by AMFI on making distributors more accountable for the service they deliver. If we don't do this ourselves, we run the risk of our regulator doing away with commissions altogether as an investor protection measure, when actually a more practical solution would be enforcing delivery of services for commission paid.
Is this all coming too late? Is the die already cast on the RIA regulations? If indeed the final RIA regulations need to be approved by SEBI's Board, it appears that this can happen only under a new Chairman. And if a new Chairman is willing to apply a fresh mind to this issue, why not present a viable alternative that empowers investors and maintains viability of intermediation models?
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