Pass backs of commissions on mutual funds

(From a recent issue of Moneylife- IFAs are angry and so are some others with me for this article, because I am promoting an activity that is considered illegal and unethical. I do not find anything unethical in this. The distributors started and propagate this practice. Instead of admitting and stopping this , they blame me for writing about this. ) Mutual Funds: Direct plans & pass-backs 9 comments+ COMMENT R BALAKRISHNAN | 29/01/2013 03:05 PM | Commission-free ‘Direct Plans’ for mutual funds may turn out to be less attractive than they appear Direct Plans, under which you can buy mutual fund units directly from asset management companies (AMCs), have just come into force. They charge you less (since there is no distributor commission involved), which means higher returns. But, for this, it is important to have an understanding of the commission structures, the pass-back mechanisms, etc. Remember, most distributors will pass back commissions in some form or the other. You should add it to your investment, to arrive at your total returns. The practice of pass-back of commissions is a vexed one. At the outset, let me make it clear that I am a proponent of pass-backs of commission by intermediaries to the investor or anyone else who facilitates the investment. I see nothing wrong with it. Unfortunately, some AMFI (Association of Mutual Funds of India) members thought that they could increase the retention of commission for their ‘associates’ by prohibiting the distributor from passing back commissions. Did it prevent any pass-backs? Or did the intermediaries find ways to simply ignore the circular? Or did intermediaries use the excuse of the circular to deny pass-backs to some investors? The answer is a yes, to all of the above questions. Pass-back of commissions is normal. The same is the case for company fixed deposits. In fact, the habit of pass-backs is so entrenched, that I recall that a reputed corporate group would give ‘taxi fares’ in lieu of commissions to those who directly invested in the company’s fixed deposits. The taxi fare would be equal to exactly ½% of the amount invested. Direct Plans are OK for some companies. Most do not like Direct Plans because it seals one route of siphoning money. Many corporates used to ask brokers to give the pass-back in the form of ‘donations’ to their pet charities or by asking for air tickets, holiday vouchers, hotel stays or foreign trips for their families. Some companies go to the extent of asking the broker to provide ‘soft’ support like Reuters/Bloomberg terminals (which cost a couple of thousand dollars a month), buying laptops, mobile phones, etc. In many cases, the corporate would negotiate the commission with the AMC and then ‘route’ it through the intermediary, who would get to keep a fraction of it. Now, with Direct Plans, they will have to find a new justification to avoid it. Perhaps they will engage ‘advisory’ services for investing in mutual funds. Or they can simply play one mutual fund against the other and get some direct kickbacks from the fund houses themselves. Pass-backs have even taken the form of AMCs buying ‘Sodexho’ passes and distributing them to the key officials in investors’ offices. I recall meeting treasurers of financial institutions for investments in some specific funds and, finally, when the investment was made, it would bear the stamp of some unknown broker whom I had never met! This broker had an ‘arrangement’ with the executive in the financial institution! They could easily have given it to me directly. Their return would have been the same. In a Direct Plan, they would get a higher return, since there is no broker. Direct Plans for equity funds should be cheaper by at least 100-150 basis points, since that is the range of commission paid to distributors. If mutual funds only cut total expenditure by ½% to ¾%, it makes sense to go through the distributor and take the pass-back from him. AMCs will try to cheat by reducing the total expenses by less than what they pay as selling commission. I heard, recently, that a fund house was paying around 5% upfront for an investment in a tax-saving fund. If they have a Direct Plan, it means the difference has to be an average of at least 1-½% each year (assuming three-year lock in). If not, they are taking the investor for a ride. Check your numbers before plunging into any Direct Plans. A distributor may offer you a better option and a higher total return.