A quick survey of the new fund offers (NFOs) launched in January 2006 shows one thing: though the entry load (the upfront distributor commission, usually 2.25 per cent), or the lack of it, is advertised in bold letters, tucked away in the inside pages of the offer document is a paragraph that says ‘‘The initial issue expenses upto to a maximum of 6 per cent of the initial resources raised by the scheme, will be amortized over a period of five years as permitted under Sebi (Mutual Fund) Regulations 1996’’.
This means that 6 per cent of whatever a new fund offer collects during the NFO period can be charged to the scheme, split over five years. Meant to take care of the advertising and marketing costs, most of this money is routed to the distributors as their commission in the form of cash and a percentage of the amount raised.
Nothing wrong with that, except that the investor believes that the commission in an NFO is either zero or 2.25 per cent at most and are unaware of this other hidden charge, that can add up to as high as 7 per cent. These have also encouraged malpractices in mutual fund distribution.
Practices that benefit the distributor and the large investors who play ball. Who loses? The long-term retail investor. Here’s how:
Fund house XYZ launches yet another NFO. It offers the large distributors Rs 100-125 per application (irrespective of the application amount on each form) and 2.25-5 per cent of the amount collected. All fund houses offer cash incentive to the distributors.
Now the market splits across regions. In the urban centers, the six large foreign banks have a stranglehold on the market and they negotiate commission directly with the fund. These banks are not interested in the cash incentive, they have high net worth individuals (HNIs) who ask no questions.
Banks rotate high net worth investors money by liquidating old schemes to buy NFOs. Bank gets fat fees, meets revenue targets and HNI gets annual statement where portfolio has grown 20 per cent in a market that has returned 40 per cent. HNI is usually too busy to figure out how much he could have made had he not churned his portfolio.
At the other end of the market is the large distributor in the smaller towns and cities who plays the multiple entity and multiple Association of Mutual Funds of India (AMFI) Registration Number (ARN) number game. Fund houses club multiple applications by the same name and treat it as one. So a person making a straight Rs 1 lakh application will give the broker only Rs 100 as cash incentive.
If the broker could break this up into 10 or 20 application forms, he earns Rs 1,000 or Rs 2,000. The distributor gets family and associates to sit for the AMFI exam and gets multiple ARN numbers, each of which can now be used to split the application. The Indian Express has papers that show eight ARN numbers on different names that have one address on them.
Now the game moves up one notch. The distributor and the HNI now get together. HNI splits his Rs 1 lakh application into multiple entities and also across the various ARN number of his friend distributor and applies on the last day of the NFO closing. Part of the upfront cash is shared with the investor as is the percentage commission.
Once the NFO opens for subscription, the investor redeems at once. The whole process earns the investor cash for rotating his money, the distributor gets his cut, they have both skimmed the cream off the fund, leaving the rest of the investors to bear the 6 per cent cost over the next five years.
The rush of new fund offers with equity schemes that are no different than what the fund houses already have, shows that the game is still being played hard and fast. Some fund houses like Templeton, Fidelity and HDFC, who are trying to break out of this distributor stranglehold are trying out solutions like exit loads and closed end funds.
Of course, all it takes is Sebi to change the amortization rule. But Sebi is still waiting for the funds and AMFI to sort out the mess.
Tomorrow: How and why the retail investor pays?