Mutual Fund Commissions on Tax Saving Schemes

Since some of you will be investing in tax saving schemes for the rest of the year, note that there are pretty good commissions being offered to advisors for selling the scheme. The most recent mail I have:

Upfront is what advisors get paid when you invest. Trails are after 1 year of holding, 2 years of holding etc.

How can they pay such high commissions? In tax saving schemes, your funds are locked in for three years. Each year, there is a 2.5% management charge AMCs can take – for a total of 7.5% – of course some AMCs charge lesser fees but I wouldn’t count on less than 2% a year, due to these high commissions.

Will fund performance suffer? Er…nearly every mutual fund is trying to max out its AMC fees now to pay upfront commissions and new schemes are on “special commissions” every day. So EVERY mutual fund house is likely to max its commissions. Therefore, relatively speaking, there may not be much of a problem. And if the fund can grow by 2.5% – it’s management fee – it’s all even. (And most AMCs must believe they can, because heck, the GDP is growing 6%)

Does it make more sense to go DIRECT?

Let’s do the calculations. Assume a fund with 100 investors with Rs. 100,000 each , all of whom come through advisors. The fund has a corpus of 1 crore, and can charge Rs. 2.5 lakhs as expenses, or Rs. 250,000. This can be split as:

Upfront: Rs. 100,000 to advisors (Rs. 1000 for each investor’s advisor – or 1% upfront)
Trail: Rs. 50,000 (Rs. 500 or 0.50% 1st year trail)
AMC retains: Rs. 100,000 for it’s management expenses and profits.

Each advisor makes Rs. 1,500 as commissions and the AMC gets 100K.

Think about what happens if the fund becomes 50 advisor-based investors and 50 Direct investors. The Direct investors have no commissions – upfront or trail. The fund can still charge Rs. 250,000 as fees – since SEBI permits 2.5% to be charged. That can then be split as:

Upfront: Rs. 75,000 to advisors (Rs. 1,500 for 50 advisors, or 1.5%)
Trail: Rs. 50,000 to advisors (Rs. 1,000 per advisor or 1%)
AMC Retains: Rs. 125,000.

Each advisor gets Rs. 2,500 and the AMC gets 125K.

(Note that commissions here are higher on a % basis, because the fund house is charging 2.5% but distributing among lesser advisors – it can therefore offer higher % commissions)

Basically, if you go DIRECT, you are supposed to get better fund management due to lower commissions – but as you can see, in practice it means that advisors stand to make more. If anything is left, the AMC rakes it in.

AMCs complain that people are being guided towards insurance products which offer huge commissions; so mutual funds have to compete. That is true and IRDA should also ban all upfront charges. If anything, insurance is an even worse investment.

Yet, Mutual funds need smarter investors but as you can see above, the smarter ones will figure out the commission scales are tilted against them. Smarter products must be brought – for one a zero load, low cost mutual fund will be nice. I will be happy to see a no-load fund with expenses capped at 0.5%. I know that Nifty BEES (An exchange traded fund from Benchmark) fits the bill – you do pay some brokerage getting in though. (As Commenter DK points out, Nifty BEES is not an ELSS fund, so that’s not quite a tax saving instrument) Quantum Mutual fund has no load but it charges 2.5%, thus negating any no-load benefit.

Disclosure: I am an AMFI registered individual and can get these kind of commissions if I want to sell them. And it’s entirely legal to disclose these commissions – in fact by new SEBI rules you are required to do so if you are an advisor.

It’s against AMFI guidelines to pass this brokerage back to the investor, but many advisors still do it: if your advisor is passing commission back, now you know how much to ask of him!

(On that note I think it should be perfectly legal to pass commissions back. If an advisor wants to pay back commission why should there be a rule to stop him from doing so? It’s a big-brother rule that makes no sense at all, so it happens without any real enforcement. But since it is not allowed, so no one can openly say they are giving commissions back)

I am in the process of registering with mutual funds as an advisor, and feel free to contact me for any support. If any advisor is not selling you a fund because he is not getting any or enough commission, please let me know – I can help. I don’t care about upfront commissions at all.