How SEBI killed the IFA: A murder investigation report

August 24, 2010 01:56 PM
S Rodrigues
Source:  http://www.moneylife.in/article/72/8477.html

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The IFA (Independent/Individual Financial Advisor) is on life support — suspected dead — and the prime suspect is the Securities and Exchange Board of India (SEBI). The acronym is alternatively called in a parallel world, the Systematic Elimination of Brokers and Intermediaries
Now the distributor is on the incubator, on life support, suspected dead. We know how he got there - is SEBI going to revive him or remove the life support system?
Let us study the history of this crime, and discover what the investigation reveals:
1. The Golden Beginning:
The golden days of mutual funds (MFs) were when they were a hard sell. The IFA educated the investor about risk-control measures, liquidity, profitability over a gestation period, tax benefits and working of an MF and introduced them to asset allocation before putting down a single rupee. However, the investor wanted to hear about the 'guaranteed returns' that he was addicted to - thanks to the Unit Trust of India (UTI), fixed deposits, etc. So he missed the boat but not before dipping his feet into the swimming pool by investing small amounts. The IFA said to himself, "Today he is dipping his toes into the swimming pool - tomorrow he is going to jump in." Right enough!
2. The 'Unethical Practices' begin:
Once the investor started to take a dive into mutual funds, they (mutual funds with the active connivance of some IFAs) introduced their first unethical practice - 'dividend stripping'. They did not inform the investor that the net asset value (NAV) falls to the extent of the dividend amount and that there is no advantage in chasing dividends (in fact there is a disadvantage as the investor is paying a load on money merely returned to him - without any fund management).  It was dividend that attracted the inflows and not the client's investment goals nor the fund performances - the party continued.
3. The 'Unethical Practices' grow:
The next big 'con' encouraged by mutual funds was "NFOs" (New {and unnecessary} Fund Offers). Mutual funds did not educate the distributors and investors that the NAV does not generate any return (but rather the 'Portfolio' does) - thus whether the NAV is Rs10 or Rs10,000 does not make any difference - it is merely a mechanism for 'entry' and 'exit'! They instead sold 'Rs10 as 'cheap'. This resulted in thousands of superfluous schemes being launched. SEBI did a great job of stifling the NFOs by abolishing the entry load.
4. Some 'Greedy Distributors/IFAs':
The biggest evil is yet to be highlighted - it is the 'banker' - who sold MFs based on head office's recommendations, which in turn were based on target collection shortfalls - client needs were nowhere in the picture. If the client needed 'debt' - sell 'equity' because there lies the shortfall in targets and the HO's rewards for them.  To make things worse, these qualified MBAs would each come with their own ideas and churn the client's portfolio many times and get multiple credits towards their sales targets. Next they would get a job promotion based on this (churning) performance and the new MBA would take his place with his bright ideas and rape the investor again with another few churns.
Some greedy IFAs joined this circus and sold equity as a 'short-term' instrument and wrongly taught investors that 'share funds have to be bought and sold quickly' - they did not inform the investor that they merely have to make an 'asset allocation' and the fund manager will be doing the 'buying and selling' for them.
Thus I maintain my stand that it is not merely 'education/educational qualifications' that will revive the industry but rather 'dedication' - let the investor decide who is dedicated and who isn't!
SEBI, too, messed up over here. When MFs set the exit load on share funds as 1% for those who exit before three years (gestation period of equity product) - SEBI in its benevolence to become popular among the investors reduced this to one year - this move encouraged churning after one year - thus doing more harm than good to the industry, which is suffering from too much short-term money and views.
5. SEBI lands its death blows:
A person is satisfied and gives his best if:
a. He is well-paid - if you pay peanuts you will get monkeys - why should you attract a qualified and dedicated force consisting of the brightest minds if the payment is inadequate? Not only was the payment made inadequate, the upfront brokerage was hastily abolished without setting into place international 'best practices'.
b. He is sufficiently motivated - SEBI and the media continuously focused on the unethical practices of a few distributors. The whole distributor community got demoralised and was viewed with suspicion - as cheats. How can you expect performance from a demoralised force?
c. He has the necessary job security - SEBI has released a diarrhoea of circulars and the entire MF industry is of the view that they all need to go on a long holiday. With the goalpost continuously being shifted, the IFA is totally disoriented and refuses to sell - this has rubbed on to the investor who is resorting to selling to invest in bank deposits and properties.          
Let me elaborate:
a. 'Investor Going Direct' is an injustice to a distributor:
A person approached me for the investment of a huge sum. I explained mutual funds to him in great detail. He wanted MF portfolio reports and performance comparisons - these were sent by email. He wanted a detailed plan with a suggested asset allocation - these too were promptly sent to him. After four months of discussion and deliberation - on 4 January 2008 I received an email 'Happy New Year - I heard that now we can now invest directly in mutual funds. Thanks for all the help and advice.'
Now do you think this is fair??? Why on earth should I spend hours of my time on an investor when I do not know whether I will be adequately remunerated? So thanks to this move of SEBI I have turned tight-lipped and sketchy in my explanations, I now give only 10% of myself - as against 120% previously and new investors are strictly taboo (at a time when SEBI wants them popularised).
Thus thanks to SEBI I am no longer doing justice to the investor community. This move to let the investor go directly is retrograde, with the abolishing of the entry load it has become obsolete - but SEBI will not remove it from the statute book as they will be losing brownie points.
b. The international 'best practices' remuneration structure was not put in place before abolishing loads and commission - death for the small investor:
The international practice of the investor and distributor mentioning a mutually negotiated commission rate on the application form and both signing against it should have been put in place before commissions were abolished. This would have resulted in a smooth transition to the new regime. The move on the part of SEBI of only implementing half the job has won a lot of investor brownie points, a place in the history books but has destroyed the remuneration and motivation of IFAs and has rattled the whole MF industry.
Mutual funds were formed to mobilise the savings of the small investor. But with no upfront brokerage and with the laborious and expensive billing process, who would be interested in the small investor who wants to make an SIP below Rs5,000 per month or invest an upfront amount of Rs5,000 to Rs25,000? The billing would cost more than the revenue earned. Thus this populist move has been self-defeating - the small investors are rejected and no longer welcome!
c. All financial products cannot be marketed on the same remuneration:
SEBI has not understood the marketing of financial products and it is for this reason I am most thrilled they were unsuccessful in taking over ULIPs (the most expensive and mis-sold con product in the financial world - which need drastic distributor cost restructuring for some profitability to emerge).
Here is an explanation:
i. Shares and stocks are sold by giving recommendations/tips - it requires no servicing/discussions. All servicing is done by the investor directly with the demat bank/institution. It is a high-volume business with hundreds/thousands of transactions conducted daily on a low remuneration.
ii. Mutual funds required detailed explanations relating to risk control, liquidity, profitability over a gestation, tax benefits, working, etc. Regular servicing for change of address, change of name due to marriage, change of bank details, death of holder, valuation & tax statements, account statements requests, year ending account statements requests, etc, etc - take up a majority of a working day. Such services are generally rendered free although they take up a lot of time and cost much money.
Thus transactions are few and require a higher remuneration.
iii. With insurance a person sells the insecurity of death - which is a hard sell.
iv. With ULIPs they sell a combination of mutual funds and insurance. Both insurance and ULIPs have only a few strikes (if at all) in a month - so how on earth can all these products be sold and remunerated in a similar way? They each have their own dynamics and remunerative structure to retain quality talent. If SEBI took over ULIPs they would become extinct like the dinosaurs and crumble like the MF industry!
d. Unnecessary focus on commissions:
When SEBI abolished the entry load and upfront commissions and focused on commissions, it did the following:
i. Created huge entry barriers due to which bright and clever minds could not enter the industry. The commission given by mutual funds out of their own resources was too low - new entrants did not have the ability to charge a fee.
ii. Around 80% of the IFAs disappeared (100% would have disappeared if trail brokerage commission was also abolished) and enrolled in employment exchanges or joined call centres. With a depleting force how can there be increased market penetration?
iii. All expansion plans into rural areas and branch expansions, etc, were abandoned.  In fact many of my colleagues shut down branches.
iv. The lack of remuneration de-motivated persons from getting professionally qualified thus stifling the quality of growth in the industry.
v. The whole focus was drawn to commissions, compiling commission sheets, etc rather than reading news articles, studying portfolios, learning/using tools of financial planning, meeting clients needs, etc - the quality of advice deteriorated as more time was spent on such useless activities.
The SEBI chairman does not pin his salary structure on his shirt, Value Research or any financial magazine does not mention how a big article was published due to the support of an advertisement - so why should a mutual fund distributor reveal his (now - token and miserable) commissions when he meets an investor? In fact, the task is daunting and could take months to prepare - as the commissions on 'all competing schemes' need to be displayed i.e. thousands of schemes - an impossible task! This is how the bureaucracy burdens you with burdens nobody can bear - so that they can crucify you anytime!
All this shifts the focus from the client's needs to the commission structure - thus getting everyone 'out of focus'. With the current rule even the best scheme attracts the suspicion of the investor if it pays the most commission!
It would save a lot of time if instead the regulation provided that:
a. The investor can log into CAMS/Karvy/AMFI and find out the commissions payable by all schemes by entering the distributor code.
b. Each mutual fund scheme is rated by CRISIL (or any other rating agency). And only those selling funds below a certain rating should be forced to reveal the commission received thereon and competing schemes. My 25 years experience in this line tells me that focusing on commissions is a bad idea, puts the emphasis on the wrong thing and get everything 'out of focus'.
vi. The distributor also suffers from the stigma of other injustices in relation to commissions, e.g.:
a. While everyone is exempt from service tax for service income up to Rs10 lakh, the mutual fund distributor's commission is subject to service tax deducted at source from Re1. Why is SEBI not acting in this matter and making representations to the government? It is now three years and this injustice continues - distributors earning more than Rs10 lakh have lost more than Rs3.6 lakh due to this move.
b. A manufacturer does not ask a wholesaler how much of the produce he is going to personally consume and charge him a retail price thereon. An Insurance Distributor gets a commission on his own policy!
So why has an MF distributor to disclose his personal investments and not be paid thereon? It does not make sense especially since upfront commission payment from investor money has been abolished.
This rule was introduced so that persons would not become distributors merely to earn commissions on their own investments. With the professionalization of the distribution business this provision has become obsolete and needs to be abolished.
c. AUM (Assets Under Management by a distributor) is tantamount to goodwill created, as an investor is free to change his broker if he is not happy with him. Thus AUM is nothing but 'retained assets' i.e., goodwill. However there is no uniform mechanism to transfer the AUM on change of the organisational structure, for the distributor to sell the AUM on retirement, for the heirs to sell the AUM within a reasonable time after the death of the distributor. Thus the distributor's 'gold nest' can easily get frittered away and is without any legal protection.
          
The fact is that for the mutual fund industry to succeed two things need to be done:
a. SEBI, MFs and distribution channels need to work ethically together as a team.  Right now there is a major conflict with SEBI. And SEBI is hated by MFs and distributors with all their might (and rightly so!).
b. The investors must be given proper product knowledge and MFs must be sold ethically. Each investment must be tied to an investor's need - so that he remains invested with a purpose.
Until this comes about, the MF industry is not going to expand but will instead stagnate.

c. He has the necessary job security - SEBI has released a diarrhoea of circulars and the entire MF industry is of the view that they all need to go on a long holiday. With the goalpost continuously being shifted, the IFA is totally disoriented and refuses to sell - this has rubbed on to the investor who is resorting to selling to invest in bank deposits and properties.           
Let me elaborate:
a. 'Investor Going Direct' is an injustice to a distributor:
A person approached me for the investment of a huge sum. I explained mutual funds to him in great detail. He wanted MF portfolio reports and performance comparisons - these were sent by email. He wanted a detailed plan with a suggested asset allocation - these too were promptly sent to him. After four months of discussion and deliberation - on 4 January 2008 I received an email 'Happy New Year - I heard that now we can now invest directly in mutual funds. Thanks for all the help and advice.'
Now do you think this is fair??? Why on earth should I spend hours of my time on an investor when I do not know whether I will be adequately remunerated? So thanks to this move of SEBI I have turned tight-lipped and sketchy in my explanations, I now give only 10% of myself - as against 120% previously and new investors are strictly taboo (at a time when SEBI wants them popularised).
Thus thanks to SEBI I am no longer doing justice to the investor community. This move to let the investor go directly is retrograde, with the abolishing of the entry load it has become obsolete - but SEBI will not remove it from the statute book as they will be losing brownie points.
b. The international 'best practices' remuneration structure was not put in place before abolishing loads and commission - death for the small investor:
The international practice of the investor and distributor mentioning a mutually negotiated commission rate on the application form and both signing against it should have been put in place before commissions were abolished. This would have resulted in a smooth transition to the new regime. The move on the part of SEBI of only implementing half the job has won a lot of investor brownie points, a place in the history books but has destroyed the remuneration and motivation of IFAs and has rattled the whole MF industry.
Mutual funds were formed to mobilise the savings of the small investor. But with no upfront brokerage and with the laborious and expensive billing process, who would be interested in the small investor who wants to make an SIP below Rs5,000 per month or invest an upfront amount of Rs5,000 to Rs25,000? The billing would cost more than the revenue earned. Thus this populist move has been self-defeating - the small investors are rejected and no longer welcome!
c. All financial products cannot be marketed on the same remuneration:
SEBI has not understood the marketing of financial products and it is for this reason I am most thrilled they were unsuccessful in taking over ULIPs (the most expensive and mis-sold con product in the financial world - which need drastic distributor cost restructuring for some profitability to emerge).
Here is an explanation:
i. Shares and stocks are sold by giving recommendations/tips - it requires no servicing/discussions. All servicing is done by the investor directly with the demat bank/institution. It is a high-volume business with hundreds/thousands of transactions conducted daily on a low remuneration.
ii. Mutual funds required detailed explanations relating to risk control, liquidity, profitability over a gestation, tax benefits, working, etc. Regular servicing for change of address, change of name due to marriage, change of bank details, death of holder, valuation & tax statements, account statements requests, year ending account statements requests, etc, etc - take up a majority of a working day. Such services are generally rendered free although they take up a lot of time and cost much money.
Thus transactions are few and require a higher remuneration.
iii. With insurance a person sells the insecurity of death - which is a hard sell.
iv. With ULIPs they sell a combination of mutual funds and insurance. Both insurance and ULIPs have only a few strikes (if at all) in a month - so how on earth can all these products be sold and remunerated in a similar way? They each have their own dynamics and remunerative structure to retain quality talent. If SEBI took over ULIPs they would become extinct like the dinosaurs and crumble like the MF industry!
d. Unnecessary focus on commissions:
When SEBI abolished the entry load and upfront commissions and focused on commissions, it did the following:
i. Created huge entry barriers due to which bright and clever minds could not enter the industry. The commission given by mutual funds out of their own resources was too low - new entrants did not have the ability to charge a fee.
ii. Around 80% of the IFAs disappeared (100% would have disappeared if trail brokerage commission was also abolished) and enrolled in employment exchanges or joined call centres. With a depleting force how can there be increased market penetration?
iii. All expansion plans into rural areas and branch expansions, etc, were abandoned.  In fact many of my colleagues shut down branches.
iv. The lack of remuneration de-motivated persons from getting professionally qualified thus stifling the quality of growth in the industry.

v. The whole focus was drawn to commissions, compiling commission sheets, etc rather than reading news articles, studying portfolios, learning/using tools of financial planning, meeting clients needs, etc - the quality of advice deteriorated as more time was spent on such useless activities.
The SEBI chairman does not pin his salary structure on his shirt, Value Research or any financial magazine does not mention how a big article was published due to the support of an advertisement - so why should a mutual fund distributor reveal his (now - token and miserable) commissions when he meets an investor? In fact, the task is daunting and could take months to prepare - as the commissions on 'all competing schemes' need to be displayed i.e. thousands of schemes - an impossible task! This is how the bureaucracy burdens you with burdens nobody can bear - so that they can crucify you anytime!
All this shifts the focus from the client's needs to the commission structure - thus getting everyone 'out of focus'. With the current rule even the best scheme attracts the suspicion of the investor if it pays the most commission!
It would save a lot of time if instead the regulation provided that:
a. The investor can log into CAMS/Karvy/AMFI and find out the commissions payable by all schemes by entering the distributor code.
b. Each mutual fund scheme is rated by CRISIL (or any other rating agency). And only those selling funds below a certain rating should be forced to reveal the commission received thereon and competing schemes. My 25 years experience in this line tells me that focusing on commissions is a bad idea, puts the emphasis on the wrong thing and get everything 'out of focus'.
vi. The distributor also suffers from the stigma of other injustices in relation to commissions, e.g.:
a. While everyone is exempt from service tax for service income up to Rs10 lakh, the mutual fund distributor's commission is subject to service tax deducted at source from Re1. Why is SEBI not acting in this matter and making representations to the government? It is now three years and this injustice continues - distributors earning more than Rs10 lakh have lost more than Rs3.6 lakh due to this move.
b. A manufacturer does not ask a wholesaler how much of the produce he is going to personally consume and charge him a retail price thereon. An Insurance Distributor gets a commission on his own policy!
So why has an MF distributor to disclose his personal investments and not be paid thereon? It does not make sense especially since upfront commission payment from investor money has been abolished.
This rule was introduced so that persons would not become distributors merely to earn commissions on their own investments. With the professionalization of the distribution business this provision has become obsolete and needs to be abolished.
c. AUM (Assets Under Management by a distributor) is tantamount to goodwill created, as an investor is free to change his broker if he is not happy with him. Thus AUM is nothing but 'retained assets' i.e., goodwill. However there is no uniform mechanism to transfer the AUM on change of the organisational structure, for the distributor to sell the AUM on retirement, for the heirs to sell the AUM within a reasonable time after the death of the distributor. Thus the distributor's 'gold nest' can easily get frittered away and is without any legal protection.
           
The fact is that for the mutual fund industry to succeed two things need to be done:
a. SEBI, MFs and distribution channels need to work ethically together as a team.  Right now there is a major conflict with SEBI. And SEBI is hated by MFs and distributors with all their might (and rightly so!).
b. The investors must be given proper product knowledge and MFs must be sold ethically. Each investment must be tied to an investor's need - so that he remains invested with a purpose.
Until this comes about, the MF industry is not going to expand but will instead stagnate.
 
(Ms S Rodrigues is a financial and investment consultant based in Pune. She has, of course, used a pseudonym).