Cheaper option may not be better

Retail investors, I am afraid, may end up losing more than they gain.

The introduction of “direct” plan, which will come into effect from 1 January 2013, in all mutual fund (MF) schemes has started to give insomnia to distributors. In a circular that the capital markets regulator, Securities and Exchange Board of India (Sebi), issued on 13 September, it said that all fund houses have to provide a “direct” option in all their schemes, catering to investors who wish to invest with a fund house directly without any distributor’s help. The direct plan will, therefore, have a lower expense ratio and a different net asset value (NAV). Typically, while the asset management companies pay upfront charges to distributors from their own pockets, they pay the trail fees (for as long as the investor stays invested in the scheme) out of the total expense ratio (the current upper limit is 2.5%) that fund houses charge you, the investor. Sebi thinks that if investors avoid distributors, they should not pay agent charges.

The first brunt, as I pointed out in one of my earlier columns (http://tinyurl.com/96svjhn), will be felt by debt funds, especially liquid funds. Typically, at least 95% of investors in liquid funds are companies and institutions. So distributors who service these clients—let us call them institutional distributors—will face a direct threat to their livelihood and existence.

Assume a liquid fund’s total expense ratio (TER) is 60 basis points (bps), of which 15 bps is trail fee paid to distributors. Its direct plan, therefore, will have a TER of 45 bps. If a large company invests Rs.1,000 crore in the normal plan, it gets Rs.1,065.5 crore after a year, assuming the fund returns 7%, in the direct plan compared with Rs.1,064 crore in its normal plan (with embedded distributor charges). That’s a saving of Rs.1.50 crore, straightaway.

Why will institutions then go via distributors? Once the board of directors come to know of the massive savings, industry sources feel they will mandate their treasury departments to save these costs, shun the distributors and invest directly. High net worth individuals and savvy investors may follow suit.

Institutional distributors, such as Mata Securities India Pvt. Ltd, SPA Capital Services Ltd, JM Financial Services Ltd and Enam Securities Pvt. Ltd, are running scared right now. If their clients shift to the direct option, these distributors stop earning trail fees. Years spent, if any, in acquiring the client, retaining and servicing them will now lead to the client opting for a cheaper option, just because there is one.

But will the clients shift? I won’t be surprised if they do. A former employee in the sales and marketing division of Franklin Templeton Asset Management (India) Pvt. Ltd tells me that when they had launched an institutional plan (a first in the MF industry at that time) in one of their debt funds (whose expense ratio was just 10 bps cheaper than the normal plan, which later on came to be known as the “retail” plan), almost “the whole industry” launched a similar plan. “There is zero doubt in my mind that, of the 40-50% of investors that constitute the institutional pie, about 80% will move to the direct option,” he says, on condition of anonymity. At most, the companies will hire a person or two to look specifically into its treasury investments into MFs.

There is a twist. If fund houses feel that they need to go that extra mile to service institutional clients, they may add a charge to the direct plan, which would not otherwise apply to the normal (distributor) plan. As a result, the difference in the TER of the two plans may not be much after all.

In the meantime, three people associated with the distribution and MF industry (an MF industry professional-turned-banker, the head of one of India’s largest national distributors and the head of one of India’s largest institutional distributor) met a senior Sebi official last week to suggest an alternative. Their plan: let investors opt for the direct plan if they wish, but allow them to route their investments through their distributors who should be allowed to put his agent code on the application form. That way, distributors can charge a fee to clients and continue to service them since the investments will be under the distributor’s radar. The Sebi official seems to have told them that he will look into it.

Is it fair? In theory, a cheaper option for direct investments is a good idea. If you do not take the distributor’s help, why should you pay them? But a carte blanche introduction of direct plan may lead to misuse more than genuine benefit for the right people. Fund houses such as Quantum Asset Management Co. Ltd, which charge lower fees because they don’t pay distributor fees have survived so far. If, like in the US where fund houses are free to adopt either a no-load or a load model, the Indian MF industry is given a choice, then firms will be free to go the Quantum way if they feel strongly about agent compensation.

While retail investors may have been in Sebi’s minds when it thought of the “direct” plan, it is the institution that will reap the benefits. Retail investors, I am afraid, may end up losing more than they gain. Operational problems as well as lack of adequate knowledge in selecting the right fund may come to haunt them at a later date. A good agent can always guide and help the investor. But once an investor takes the direct route, there’s little an agent can do later if there’s a problem. Cheaper options may not be the better option, after all.

Source: http://www.livemint.com/Money/vOG97J9ZSYOddJUa09eb6O/Cheaper-option-may-not-be-better.html?google_editors_picks=true