Mutual Fund distributors act as the bridge between the asset management companies and investors. For most first time investors, taking advice from a distributor adds value in knowing about the available options and choosing the suitable option. But, like any other profession, the way distributors and incentivised can have a profound impact on the quality of advice provided by them.
Let us understand the commission structure of Mutual Funds and how it can influence the advice provided by a distributor.
TYPES OF COMMISSIONS
There are primarily two types of commission.
1. Upfront Commission
This is the one-time payment to a distributor my an asset management company when a distributor sells a mutual fund scheme to a client.
2. Trail Commission
Trail commission is a recurring commission paid by an asset management company to a distributor based on the mutual fund schemes sold through the distributor. So, your distributor will receive the trail commission till your redeem your mutual fund units.
AMCs calculate trail commission for a distributor on the daily net asset under management of the distributor.
Note: The actual percentage of commission paid to the distributor depends on the AMC, the type of mutual fund scheme and location because AMCs often pay a higher commission to distributors in cities with low mutual fund penetration.
WHAT IS UPFRONTING OF THE TRAIL COMMISSION?
Sometimes the asset management may pay the trail commissions in advance as a lump-sum to the distributors instead of recurring payments. This is called upfronting of trail commission.
IMPLICATIONS OF TYPE OF COMMISSIONS
An upfront commission incentivises the distributors to increase the number of transactions as the distributor receives the upfront commission on new transactions. This means that distributors may often encourage investors to churn their mutual fund portfolio even if it is not required. This increases the transaction costs for the investors and lowers the return for the investor.
The trail commission is tied to the NAV of the units already bought through the distributor and the distributors receive trail commission till the units are redeemed. The trail commission incentivises the distributor to increase the asset under management, choose mutual funds which are expected to perform better and encourage investors to keep invested for longer.
The role of regulation is to encourage a commission structure which aligns the incentives of the distributors with that of the investors. Keeping that in mind, SEBI has in October 2018 mandated a full trail commission, banned upfront commissions and upfronting of trail commission except in the case of SIPs.
Upfronting of trail commission for SIPs is allowed in case of first-time mutual fund investors up to 1% for maximum 3 years. This will require the R&T agents to identify the first time investors using PAN numbers.
In the meantime, upfronting for SIPs will be allowed on SIP inflows of maximum Rs. 5000 per month, per investor across all schemes of a mutual fund. This upfronting shall be up to 1% of total SIP inflows for a maximum of 3 years.
Additional TER of 30 basis points (0.3%) for the individual investors located beyond the top 30 (B 30) cities. The additional commission for the addition TER can be paid in trail only.