Impact of Trail commission on your Mutual Fund Returns

There are a number of ways by which we grow our money drop by drop to build at least a lake of wealth for future consumption. After taking care of Wealth protection by way of insurance we recommend delving into Wealth creation keeping Asset Allocation in mind and investing in Debt and Equity to create a long term corpus that will not only help meet our financial goals but also let us indulge in a little bit of luxury if the corpus permits, as an incentive for such long term savings.

The Equity part of the portfolio can be built with direct stock investing or through Mutual funds the latter being the preferred route for a major part of the population as the effort involved in selecting buying and tracking individual stocks not only needs acumen and eye for detail but also time and temperament that many lack. Thus Mutual funds are the preferred route for growing money.

Of the several expenses that one pays to the AMC to manage a scheme there is a lurking element called Trail commission that not many are aware of. Trail commission, put simply, is the loyalty fees paid to the distributor for marketing and bringing the business. This is completely justified because the advisor/distributor has shown the way for a customer to invest in the fund, at times even discussing in length why that particular scheme is a fit for a portfolio [Planners must do this anyways!]. Thus it is right that the distributor gets paid the trail commission. There is a class of investors who go directly with the AMC. Many of them might get tips from newspapers, magazines, blogs and forums and also invest by word of mouth/recommendation received from friends and family and may choose to go DIRECT as well. The AMC charges a trail commission for such DIRECT customers as well. So how do the AMCs do it?

Trail commission can be between 0.2 to 0.8% (no limits but usually sub 1%) for equity funds and much lower for Debt and Liquid funds. Each quarter the AMC deducts the trail commission from the NAV of the scheme. So if the NAV today is 100 and tomorrow due to market movement the NAV raises by 50 paise to 100.50 and a Trail commission of 0.15% (Assuming annual trail of 0.6%) is applied the final NAV is 100.3493 which will be rounded to 100.35. An unsuspecting user would assume that the NAV went up only by 35 paise while the trail has slowly eaten away some returns. Miniscule – one may think. Not really, if you consider this over the long term. Look at the attached spreadsheet here for the actual impact. This can reduce your corpus by over 11% even assuming a MF growth rate of 12% over 25 years and trail commission of 0.15% each quarter. For an initial investment of 2 lacs and continuing a SIP for Rs. 10000 over 25 years the final corpus can get reduced by ~ 25 lacs which would still be decent money after 25 years. Discounting at a long term inflation rate of 8% this amount would be worth 3.65 lacs in today’s terms – not a small amount in any sense. Imagine this money being charged for the thousands of investors!Work out the numbers yourself for your SIP amounts by clicking the excel spreadsheet  here.

Source: Outlook Money Dated 21 March 2012

Outlook Money recently organized a Mutual Fund round table and posed my question to the MDs and CEOs of several Mutual funds who had attended the meeting. You can see the responses right here. Bluntly put the answers have been wishy-washy as you can see for yourself avoiding a sensitive topic in the Mutual Fund world – on one end it says it is impossible to segregate investors and at the other end it says that these funds anyway return higher than compared to the trail being cut. Both arguments don’t hold water for obvious reasons. The AMC perhaps has not done anything to earn this DIRECT customer and it is not justified charging a trail commission to this investor.

In this highly technical world when AMCs can track down right at the point of transaction initiation if the folio’s broker needs to be paid a transaction commission of Rs.0, Rs. 100 or Rs. 150 it is not a difficult task to find out customers who are DIRECT investors. Also just because the fund returns higher one need not necessarily have to pay a trail – something that will be used for the AMC’s marketing expenses. In fact more the return more the trail as well as you saw in the spreadsheet above!. The trail commissions are the customer’s money and AMCs know this.

Is there a solution out? Perhaps yes.

Option 1 – Retain the NAV + Reduce the units held for customers charged with trail commission.

This way the DIRECT investors will see the full value of NAV retained. The customers going through a distributor will see few units shaved off their portfolio reflecting the trail that was paid. This will lead customers to ask questions on the Account statement. Honestly speaking if the Distributor has done the due diligence they deserve this but any money ‘taken’ from someone usually cause rankles. They will all want to switch to DIRECT mode making the MF industry unattractive for distributors.

Option 2 – Decrease the NAV + Increase the units held for DIRECT customers

This is the best of both worlds. This way the DIRECT investors will see the NAV slashed but compensated in the form of new additional units. The customers going through a distributor will see the NAV reduced but as is today many would not even notice while the DIRECT customers do not get penalized.

We as informed investors must write to SEBI and AMFI about this practice. It is not that they don’t know this but perhaps when there is a rise in volume of such requests from informed investors it might be considered and deliberated.

Would the AMCs listen?

Welcoming all your views on this!

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14 Responses to Impact of Trail commission on your Mutual Fund Returns

  1. Abhinav says:

    Hi Justgrowmymoney

    Excellent post!! The depth in which you have analysed the issue and brought this point forward is worth real appreciation.
    I actually was reading Outlook Money in the evening today and came across that page….even I was surprised that the answers were so illogical..I cant believe that these companies do not have a separate flagging for separate channels…its also possible that this topic might not have gained much questiioning from investors…but your post has hit it bang on…

    Lets hope for a positive move in this direction by SEBI and the respective AMCs. Thanks for the enlightening post.

    Abhinav

    • Thanks Abhinav. Truly SEBI/AMFI should step in. Understandably the MF industry leaders are worried about distribution networks going for a toss so it will need some push to get these reforms in.

  2. Anurag says:

    Dear Anand ji – Another excellent article from you. I strongly agree that maximum number of people must write to SEBI and AMFI about this practice.

    Thanks & Regards,
    Anurag

  3. pattupattu says:

    Awesome analysis. All my MF investments are ‘direct’ There is a check box when you invest in which you can clearly mention that you are going the direct way. So its easy enough to keep track.

    I am amused to see how for growth rates below 5% the differences are constant.

    Although I stand to lose by this I am not going to lose sleep over this and neither should a new investor.

    AMCs are used to the money. So even if SEBi brings about a change they can always think of another expense for direct investors.

    If one plans for a goal early enough, underestimates returns, one is bound to get a little something extra trail comm or no trail comm.

    • For growth rates below 5% the corresponding trail is also so low as well to make a difference. Since the numbers displayed are rounded to the nearest decimal the difference stays constant!

      India is perhaps one of the first countries where the entry load has been made zero. Most of our western counterparts easily pay 4%-7% as loads just to access the markets via MF. Given that SEBI was ready to take this step for the investors perhaps they might as well want to segregate Trail versus other expenses at some point capping the other expenses at say 1.25%. – 1.5% Just a wild guess really.

      I cannot agree more with you on starting early!!

  4. ram says:

    You have apparently touched the subject that requires needly attention.

    In fact, the large benefitors are banks who also act as distributors instead of individual agents.
    Such investments made innocously using internet amass to huge sums for each of the banks such as HDFC, ICICI, CITI etc.

    Given these scenarios, and treating index funds are hard to beat in the long run (though the contrary results are visible in the Indian markets), the ideal solution is to switch to Index ETFs. Even though these ETFs incur significant expense ratios to the extent of 1% which is considerably large, they remain a better choice now. Howeever, investing in ETFs require one to have a demat account, and access to a brokerage, another hassle.

    • Ram – True, Banks could be some of the largest beneficiaries of trail commissions.

      Index funds trace the market. While they will surely beat most of the Mutual funds in the very long run a significant number of MFs have beat the Index by a large margin in the last 15-18 years. India being a growth economy it is only likely the index components and the entire market can grow (not that GDP and stock market returns are necessarily related) and some schemes can beat the Index big time.

      In the US the biggest bull market was from 1949 thru 1970. Until then several schemes beat the Index. Post that active management did not yield the needed results which is when active funds started lagging the Index big time and Index fund came in vogue. In India we will be discussing about Index funds in 1 decade – until then lets ride atop MFs that provide these super normal returns.

  5. Sharat says:

    Very nice article. I learnt today something new. It is high time SEBI does away with this trailing commission for DIRECT MF investors. How do we petition this to SEBI?

  6. Sandip Sabnis says:

    excellent one…..new info for me today…..in the second last comment there is some update from SEBI….can you please elaborate?

  7. Pingback: Should We Switch To Direct Mutual Fund Plans? Calculate and Consider | Free Personal Finance Calculators

  8. Arun says:

    Good one !! Saves really good amount of money for long term investors for sure

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