Last week, the Indian mutual fund association set the cat among pigeons by announcing a number and a date. The circular dated 26 March 2015 put 1 April, that is today, as the day that the mutual fund industry will move to a cost structure that caps the upfront commission (the money that the seller of a mutual fund gets for vending the product) at 1% of the amount invested, and the trail commission (the money the vendor gets at the end of one year as a percentage of the value of the asset a year later) to be either level or decreasing over the years.

A quick recap. The mutual fund industry has gone through a decade of regulatory action on costs that cause mis-selling and has slowly become a retail investor-friendly product. What does that mean? It means that all costs have a ceiling and sit under one head. The products are comparable across the industry. There are league tables that allow do-it-yourself investors or agents to select the best funds. All of the investors’ money goes to work and nothing is deducted as commission at the point of investment.

So where are the upfronts coming from? From the companies dipping into their capital. Why is that a problem for investors; it’s not my money so why should I worry? I, as the investor, need to worry because no matter where the upfront commissions come from, they tend to modify seller behaviour in favour of the highest commission products. In 2014, the mutual fund industry aggressively launched closed-end equity funds that accounted for over three quarters of the total net inflows into the industry. Why were these sold so hard? Because asset management companies (AMCs) “upfronted" the three-year trail commission—that should have come at the end of each year—to the first year, resulting in upfronts of as high as 7% or 8%. What is the problem with that? Instead of getting induced into buying into a pedigreed scheme with at least five years of performance history behind it, investors got sold new schemes with no track record. Worse, it encouraged even good advisers into churning a part of their client’s portfolio. A doctor friend with a ₹ 2-crore portfolio saw one-quarter of his portfolio redeemed to buy new closed-end funds to harvest the high commissions. I’m advising him to move to direct plans.

Even if we move from anecdotal evidence and look at academic work in this space, we get the same answer. Upfront commissions work to maximize seller income and not investor interest. Ericson and Doyle in a 2006 paper showed that a sales culture where earnings are entirely based on commissions leads to sales practices where clients were put at risk. Stoughton, Wu and Zechner in a 2011 paper find that kick-backs to advisers from product providers are always associated with higher portfolio management fees and negatively impact fund performance, regardless of investor sophistication. Del Guercio and Reuter in a 2014 paper find that direct-sold funds outperform funds sold through intermediaries, a difference they estimate to be of 115 basis points (one basis point is one-hundredth of a percentage point) per year. Mullainathan et al. in a 2012 paper find that in 284 mystery shopper visits to financial advisers, a majority of advisers recommended investment strategies that were in line with their financial interests, such as return chasing and buying actively managed funds. Moreover, advisers steer clients away from low-fee, passively-managed portfolios to higher-fee products.

What have various countries done to stop this conflict of interest? They’ve come down heavily on commissions—not just upfront but also trail—moving entire markets to an advisory model. Through the Retail Distribution Review, the UK moved the market to a no upfront or trail model for all retail financial products, including insurance. Australia passed the Future of Financial Advice law in June 2012, and made it mandatory from 1 July 2013, which bans conflicted remuneration of any kind and requires an annual fee disclosure statement. South Africa is debating moving to a zero-upfront model.

So, is a move to cap upfronts by the Association of Mutual Funds of India a good idea? Yes. We need to move to a full trail model and capping of the upfront commission is a step along the way. What the upset distributors are not seeing is the coming implementation of the Indian Finance Code that will merge regulators such as the Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India and the Pension Fund Regulatory and Development Authority into the Unified Financial Agency. Can differential costs be allowed in such a world? If your answer is no, then ask yourself : Who is better able to deal with the market—an agent grown lazy on a 40% upfront or an agency force that is lean and hungry for investor wellbeing?

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com

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