sharing the booty

Though the 2.25 per cent entry load on mutual funds has been removed, an investor may end up paying more to distributors and financial advisors, who are considering a profit-sharing model with investors as an option to offset loss of earnings in the aftermath of ban on entry load. Distributors are trying out different fee models as the Securities and Exchange Board of India (Sebi) has asked distributors to negotiate fee directly with investors and not charge from mutual fund houses as was the practice earlier.

In profit-sharing model, the distributor takes a particular percentage of the profit from the investors above the ‘hurdle rate’ of return. Hurdle rate is the threshold level to trigger off profit sharing formula. If the hurdle rate is 10 per cent, any return above 10 per cent would mean that the investor has to pay a predetermined percentage of the profit to the distributor.

Another formula could be sharing a particular percentage of profit as per under different return slabs. For example, the distributor would take x per cent as fee if the fund gives the investor a return of 10-20 per cent, y if the return is 21-30 per cent, z…

Expert believe that the profit sharing model, which is already a common practice in portfolio management services, would evolve slowly as Sebi had allowed the distributors to negotiate their fee with the investors and therefore, it is between the distributor and the investor to decide on the fee model. According to them if a distributor helps investors to create wealth through right advice, he can ask a share of the profit they made for their clients.

The model, however, works best in case of bulk investment in equity funds as small ticket investments do not generate significant profit for the distributors. Besides, in debt funds the return in most cases is in single digit and therefore profit sharing model is not viable in the case of debt funds.

However, the model has its share of problems. First, unlike in PMS, where a wealth manager is actually making all investment decisions like picking the right stocks and selling others, in case of mutual fund, financial advisors or distributors role is limited. It is the fund manager, who makes all investment decisions – right or wrong – so, ideally a mutual fund distributor cannot take a share from the profit that the fund managers made for the investors. The other problem is the small ticket size of mutual fund investment by retail investors. In PMS, the minimum investment amount is Rs 5-10 lakh, whereas in mutual funds, it is Rs 5,000.

Another issue could be that of documentation. There are no rules or regulations on whether any agreement or contract should be signed between the distributor and investor before they enter into profit sharing deal. According to a financial advisor, though such contracts are entered into by both the parties in case of PMS, it would take some time for the same model to evolve in case of mutual fund. “These are early days, and as of now, distributors are not protected against any ‘default’ by the investors. However, once the system evolves completely, things will be in place,” he added.

Apart from profit sharing model, the other fee models looked upon by distributors are AUM (asset under management) based fee structure, under which the distributor charges a certain percentage on investor’s average yearly AUM. Some advisors charge on the basis of number of transactions (buy or sell) done by the investor throughout the year, while many others continue to charge an entry load of 1.5 to 2.25 per cent.