SEBI circular no. CIR/IMD/DF/21/2012 dated 21-Sep-2012, mandates mutual funds to provide a separate plan for direct investments, i.e., Investments not routed through a distributor. Such a separate plan shall have a lower expense ratio excluding distribution expenses, commission., and no commission shall be paid from such plans. The plan shall also have a separate NAV (Net Asset Value).

The parlance in the mutual fund world is “Regular” versus “Direct”. A quick comparison between the Direct and Regular plans of a few mutual funds gives a peek into the distribution charges that are indirectly levied on the investor who invests through Regular plans. Typical distribution charges seem to range between 0.25% and 1.25%. annually. These charges are essentially commissions paid by the mutual fund to the distributors. As the commission is paid directly by the mutual fund to the distributor by debiting the Regular plan of the mutual fund, the investor is largely left in the dark into what exactly transpires between the mutual fund and the distributor. The picture becomes murkier when one inspects the commission structures of NFOs (New Fund Offers) – however more on that in a later blog.

Lets ignore NFOs for the moment and talk about normal existing mutual funds and the commissions that exist for the distributor in Regular plans. While the charges mostly not onerous on the investor, the key question to be asked is – what is the investor getting in return from the distributor for coughing up these extra charges that are not transparent to the customer ? This is a question that is especially valid when every investor has the option to simply pick up a Direct plan directly from the fund house.

Some claim that the distributor helps with the paper work for getting the investment done. But that is hardly justified. Getting the paper work done is hardly a reason any investor would need a distributer for. Another claim is that the distributor brings before the customer a basket of investment opportunities that perhaps without the distributor would not have been available to the investor or at-least would have been more inconvenient for the investor to find. Mutual funds by themselves do not have the bandwidth to reach the length and breadth of our large country - and hence must depend upon distributors to spread awareness and give investors in far-flung areas, opportunities to get involved in the financial markets through mutual funds. Another version of the same point could be a distributor providing an online platform for investing in mutual funds. The distributor is adding value by providing a seamless investing experience for the investor. To me these are valid points and the distributor is clearly adding value to the investing process for the investor. Distributors thus provide massive reach to mutual funds and as an important financial intermediary perform a key role in the national task of financial inclusion. Distributors must rightfully be proud and unabashedly claim their commissions when they serve their role thus towards investors.

While distributors clearly have an important role to play in financial intermediation, their incentives for profit could motivate them to tie up with mutual funds that offer them higher commissions. While distributors are not allowed to advise the investor, they can chose what they want to put in front of an investor. The basket of mutual funds that the distributor offers the investor to choose from is more rather than less likely influenced by his incentive for profit. There is an inherent dichotomy between the interests of the distributor and those of the investor.

The average Indian retail investor is unable to distinguish between distribution and advise. Retail investors even in large tier-1 and tier-2 cities in India still invest largely through Regular plans. This remains so even though Direct plans are so easy to subscribe to. A quick visit to any local branch office of a mutual fund will serve the purpose. Why are retail investors still largely unaware of this clearly more cost effective way of investing ? Clearly there is not enough being done to promote Direct plans. After all who does the heavy lifting in promoting mutual fund schemes ? – it is the distributor. Why would he talk at all about Direct plans when he has nothing to gain from them ?

The argument for investing in Direct plans goes beyond the cost factor. It goes to heart of the investing rationale by cutting out the motives for profit to the person bringing the product to the investor. This is where the role of an investment adviser becomes crucial. The roles of an investment adviser and a distributor become clearly segregated. By SEBI regulation, investment advisers are prohibited from generating income from any source other than the investor directly. By eliminating commissions, Direct plans bring alignment between the investor and the financial intermediary who brings the product to the investor. Direct plans provide a means to bring genuine value added advise to the Indian retail investor – a service that the Indian investor is today starved off.