September 02, 2018

Can Distributor Commissions Impact Direct Plan Expense Ratios?

When it comes to distributor commissions, there are two sets of guidelines/ rules in particular, that fund houses are expected to follow.  The first defines the limits of how much can be paid from a mutual fund scheme to any distributor.  The second stipulates that the cost of commissions paid to distributors not be charged to investors in direct plans.  So, on the face of it, it would appear to be legally impossible for expense ratios of direct plans to be impacted by these commissions.  However, despite being sandwiched between these limitations, fund houses have a way around this. 

While most of the commissions to distributors are paid from the respective mutual fund schemes (and are clearly reflected in the expense ratios), in the case of many fund houses, there are also significant amounts paid that these fund houses cannot (or do not want to) show in the accounts of the respective schemes.  These commission payments are then made from the books of the AMCs.  If you take the top 3 AMCs (by AUM), it would appear that in 2017-18, such commission payments accounted for almost 60% of the overall expenses of these AMCs and made up over 28% of the fee that they charged for managing their schemes (a.k.a. management fee). 

The way I see it, one would have to be pretty na├»ve to believe that these payments to distributors did not influence the management fees charged by the AMC to the mutual fund schemes (including direct plans).  Based on what I saw of the financials of the top 3 fund houses, if these commission payments were not to have been made, as a rough estimate, the expense ratios of the direct plans of their equity funds, on an average, could have been lower by around 0.35%.

But even when one considers commission payments made from the mutual fund schemes, not everything may be above-board.  Here’s an example of something that I saw recently, and which I found questionable.

Over the past month or so, it appears that a number of AMCs, across several schemes, reduced the commissions that they were paying to distributors from these schemes.  In itself, this reduction in distributor commissions should have brought down the expense ratios of the regular plans of the concerned schemes.  But rather than pass the benefit of that reduction to investors,  the AMCs decided to correspondingly increase their management fees.  Obviously then, there was no reduction in expense ratios of the regular plans where this happened.  What’s worse is that this action resulted in an increase in the expense ratios of direct plans. 

To illustrate how this played out, let me put before you the break-up of the expense ratios of a certain hybrid fund, up until a few days ago, before these were changed.

Expense Ratios: Before Changes

Regular Plan Direct Plan
Management Fee 0.67%
Commissions 1.10%
Base TER
1.77% 0.67%
Other Expenses
0.33% 0.05%
GST
0.12% 0.12%
Total TER 2.22% 0.84%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

Then, a few days ago, it appears that the fund house decided to reduce the element of commissions in the base TER from 1.10% to 0.90%.  But, as I said above, rather than give the benefit of this reduction to investors, the AMC chose to increase its management fees.  After the change, this was the break-up of the scheme’s expense ratios:

Expense Ratios: After Changes

Regular PlanDirect Plan
Management Fee0.87%
Commissions0.90%
Base TER
1.77%0.87%
Other Expenses
0.33%0.05%
GST
0.16%0.16%
Total TER2.26%1.08%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

If you compare the two tables, you will notice that as a direct consequence of the  AMC’s decision to pocket the entire reduction in commissions, the expense ratio of the direct plan jumped up. 

As I mentioned earlier, this is not an isolated case.  Over the past month or so, I noticed several schemes across multiple fund houses where, in varying degrees, something similar had happened.

The expense ratio is typically described as an indicator of what a fund house charges.  Call me cynical if you like, but I look at the expense ratio as a means to know if a fund house is fleecing me.  Thanks to SEBI’s disclosure requirements, more than ever before, it has become easy to access and analyze expense ratios, and to understand how some fund houses adjust/ manipulate expense ratios to shaft investors.  It’s in our own interest to take advantage of the availability of this information.

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