The load factor: How free services will harm investors?

From 1st of August, 2009 SEBI has banned entry load on all mutual fund schemes. This in effect means that the upfront commission to distributors will be paid by the investor directly to the distributor, based on the investor’s assessment of the service rendered by the distributor. While this directive from the regulator is obviously meant to put an end to the several malpractices prevalent in the mutual fund advisory and distribution business, I feel that this step is an extreme reaction and will in the long run harm rather than help investors. There is no denying the fact that upfront incentives have in many instances been responsible for increasing the costs beyond reasonable levels for investors. It has also induced various distributors to increase their revenues by mindless redemptions, reinvestments, switch-ins and switch-outs. Many big ticket investments have been tempted by the lure of illegal pass back of upfront commissions from NFOs. Recommending schemes which had a higher upfront earning has been a common practice amongst financial advisors. However majority of investors do not have the time, expertise or temperament to manage their investments themselves. A very small percentage of savings in India find their way to the stock markets. Mutual funds are an ideal conduit for channeling small savings to the stock markets, something very essential for the growth of our economy as well as ensuring good long term capital appreciation for common investors. Over the last couple of years lured by the large investor population of our country and the attractive commission structures offered by various schemes a large number of banks, financial services companies, financial advisors and professionals entered the distribution business. Their combined efforts have helped increase the penetration of mutual funds. Encouraged by the growing investor base for mutual funds various new asset management companies were established increasing the choices available for investors. While some of the distributors did indulge in wrong practices one cannot undermine the role played by the intermediaries in increasing awareness and investor interest in mutual funds. To curb malpractices investor education was needed. This combined with tough disclosures and compliances from distributors would have gradually improved service standards in this industry. A tougher examination to obtain or renew AMFI registration alongwith strict enforcement of advisory rules would have weeded out many unethical and unprofessional advisors and achieved the objective of better service standards. By giving investors the option of direct investments earlier and removing the load on equity investments now SEBI has grossly undermined the role of intermediaries. It is human nature not to attach importance or value to a service which one is not obliged to pay for. World over there are various fee or commission based structures for distributing wealth management services. However the emphasis is always on a variable charge which the advisor fixes in discussion with his clients. Here unfortunately the accent is on a zero load and nil commission thereby putting no obligation on the investor to pay for the services rendered. This puts the onus on the advisor to negotiate some fees for his services – a very overwhelming exercise which is certain to drive a lot of professionals away from this business. Respect for any business or profession is derived not only by the competence levels of people engaged in that activity but also the legal framework supporting it. Thus a lawyer commands respect and a fee not only because of his legal expertise but also because you need a qualified legal counsel to be able to defend your case. Imagine what would happen if each and everyone one of us was allowed to appear in courts to defend our cases. It would not only undermine the role played by lawyers but also make the system of delivering justice in India far more complicated and erratic. Though the financial services and the legal fields are not exactly similar yet the example mentioned above describes in many ways the predicament of the mutual fund advisor today. After years of insipid performance mutual funds were able to finally find favour with investors during the previous Bull Run. Instead of shackling this nascent industry which has just taken off by removing the obligation on the part of the investor to pay for the services rendered by his advisor, SEBI should have introduced more stringent advisory norms and taken steps to ensure their adherence. In USA and many other countries blatant wrong advice given to clients can result in revoking of financial advisory license. For instance advising a retired, old man who lives of his savings to invest his entire money in equity markets is a clear wrong advice and will result in the advisor being forced to quit his practice in many parts of the world. Unfortunately no such step is being considered here. Even after 1st of August this advise can easily be put through by an advisor in India ( off course as long as the client agrees to pay him something for his ridiculously wrong advise) with no regulation checking his competence or intentions. SEBI believes that clients have the knowledge to determine the value of the advice being given by his advisor. Value of advice is always a matter of perception and as mentioned earlier the image of a financial advisor here has already been decimated by our regulator’s latest directive. To top it all Indians are notorious world over for being very poor paymasters for advice. Hence to expect them to pay for financial services when under no obligation to do so is impracticable. The Road ahead: A large number of intermediaries today survive on wafer thin margins. Their business model flourishes on simply tempting investors by rebating illegally the entire or a large part of their upfront commission. Their source of revenue is the extra incentive which Mutual funds usually offer on some select schemes which they are promoting. Need I say that these intermediaries recommend only those schemes that offer extra incentives? Trail commission is the other source of revenue and also determines their basket of recommended schemes. These intermediaries will be able to survive as mutual funds will still pay some small upfront incentives and trail commissions. Usually these intermediaries have very poor service standards and follow unethical and unprofessional business practices. In contrast there are professional advisors who are well qualified and employ well educated, trained service staff. Many of them have invested huge amounts in technology, infrastructure and systems to enable them to serve their clients better. They usually do not rebate or induce clients in an unprincipled way. Also they recommend schemes based on their historic performance or the risk profile of the client. Their costs of operation are high and cannot sustain on only trail commissions. Many of them will scale down or completely give up their mutual fund advisory business. Shortage of good advisors will force many clients to rely on unprofessional advisors for their investment needs. Has SEBI considered this scenario while hastily pushing through a notification which drastically changes the way mutual fund advisory business has so far been carried out?