Can High Commissions on RGESS Lead to Mis-selling? - Outside View by PersonalFN

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Can High Commissions on RGESS Lead to Mis-selling?
Feb 27, 2013

Indians have a strong inclination to hold physical assets. Real estate and Gold are the best examples. But they tend to shy away from equity assets as evident from the equity market participation of retail investors which is astonishingly low. At present, the percentage of Indians investing in equity markets is less than 5%. With advent of new technologies and platform based trading; market volumes have picked up quite a bit over last one decade but with crony base of retail investors, markets still remain narrow. Government has been trying to balance the asset allocation of Indian retail investors. While it has slammed 6% import duty on gold to discourage gold imports; it has been trying to channelise retail savings into equity markets by launching tax saving schemes such as Rajiv Gandhi Equity Savings Scheme (RGESS).

RGESS offers tax deduction to first time investors (in equity markets) having annual income of not more than Rs 10 lac. Guidelines and norms governing the scheme have been altered several times ever since the scheme was announced in Union Budget 2012. The Notable change has been the one which allowed mutual fund houses to launch RGESS eligible funds.

Does RGESS mean money gathering business for mutual funds

Ever since the entry load was banned in August 2009; the mutual funds have been losing business. Equity Assets under Management (AUM) are falling constantly even while the markets have remained buoyant. This is evident from the waning proportion of equity assets in total assets under their management in the current fiscal. Markets rose about 25% during calendar year 2012. Despite of that, proportion of equity assets as a percentage of total AUM has fallen from around 31% at the beginning of FY 2012-13 to around 23% in January 2013. Over past 2 months i.e. in December 2012 and January 2013, mutual fund houses have lost nearly 9.5 lac folios in equity schemes.

Allowing mutual fund houses to launch RGESS has given them a good opportunity to attract long term investors. However, it seems mutual fund houses have still not learned lessons from their past mistakes. They still want to use the old trick of paying high commissions to distributors. Although, banning of entry load is often blamed for the fall in equity folios with mutual fund houses; mis-selling is the actual culprit. During the multi-year bull market phase of 2002-2008; business of mutual funds proliferated. Mobilising money into equity oriented schemes was incentivised by offering attractive upfront commissions which were as high as 6% on New Fund Offers (NFOs). Mutual Fund houses even sent some of their "ace distributors" on foreign tours for having mobilised crore of rupees under NFOs. The trend is re-emerging now although to a lesser extent. Fund houses have launched RGESS eligible schemes and few have got the approval to make their on-going passively managed Exchange Traded Funds (ETFs) available under RGESS. While passively managed index funds are open ended,the ones mainly actively managedare close ended.

Can incentivising the distributors pinch your pockets?

In the foray to garner fresh AUM, some mutual fund houses are payingcommission as high as 6% to incentivisetheir distributors for garnering business under their newly launched close ended RGESS eligible schemes. Although, such a heavy loading won't be charged to investors upfront; it would be recovered from them over a period of 3 years i.e. during the lock-in period of the scheme. Recently Security Exchange Board of India (SEBI) has allowed mutual funds to charge annual total expense ratio of upto 3% (up from 2.5% earlier) on equity funds and has asked fund houses to plough back monies collected from investors as exit load into the scheme itself. And it is noteworthy that most of the fund houses that have launched RGESS eligible schemes, have given indicative annual expense ratio which may range from 2.7% to 2.75%.

New investors have not yet experienced the topsy-turvy ride of equity markets. Therefore they have been offered some safety by restricting fund houses to buy stocks which are the constituents of S&P BSE 100 or CNX 100 andthey have also been allowed to invest instocks of PSUs satisfying some predetermined criteria. In other words, by investing in closed ended RGESS offered by mutual funds the new entrants would invest in funds which are close proxies to largecap oriented funds.However, differentiating factorsare nature of schemes and the cost structure.Almost all the actively managed RGESS schemes offered by mutual funds are close ended in nature and some top performing large cap funds have an annual expense ratio in the range of 1.90%-2.50%. This means, new investors are paying higher costs to claim the 50% tax deduction benefit on their investment in a newly launched large cap fund having no track record.

The newbies who intend to invest in RGESS with asole objective of availing tax deduction, have another option of investing in open ended ETFs that passively track large cap indices such as CNX Nifty, CNX 100, Nifty Junior etc. Typically the expense ratio of these funds is about 1%. Moreover, since they passively track the index; the chances of their performance highly deviating from their indices are very low. The first time investors may not be interested in generating market beating returns but they might be interested in availing tax deduction with returns higher than those earned on fixed income instruments. Although we neither prescribe this approach as the correct one nor we say passive fund management is better than active fund management. But, in case of RGESS,there is no reason to believe that the first time investors wouldn't be better off if they invest in close ended funds. The upfront commission of 6% may lure distributors to push close ended funds just in the same manner in which some theme based NFOs were promoted at the market peak of 2007-08. Some fund houses are already promoting RGESS as "bluechip fund" to attract those who are not eligible to avail tax deduction simply for being in the 30% tax bracket or for not being the first time investors.

Another point worth considering is close ended nature of these funds would largely leave quantum of potential returns to vagaries of market conditions. In case of most other close ended funds, there is a provision of making it open ended at the expiry of pre-determined period. Some fund houses that have launched closed ended RGESS funds have been planning to launch sequels of these funds.

Recently investors who are redeeming their old folios after holding them for good 5 years is primarily because their belief in equity markets is badly shaken as markets have failed to generate attractive returns over last 5 years. Thematic funds, sector oriented funds and all other such NFOs which garnered massive AUM could do so only because of the then strong market conditions and incredibly attractive incentives paid to distributors. Many investors in these NFOs were then the first timers. They had seen others making money in the market so they too got hooked upbut unscrupulous practices in distribution played the killjoy. They did invest without even knowing the associated risk. Caveat emptor might have saved distributors and asset management companies but that has cost them business over a little longer run.

Commission paid at the rate of 6% may defy all logic and attract money. Whether investors are really aware of the risk they are exposed to may not even get attention.

Given below could be the possible catches in the sales pitch of your distributor:

Since there is no upper limit on investing in close ended RGESS funds; mutual fund distributors may try to solicit investors to put more than Rs 50,000 in the fund eyeing 6% upfront commission. It's a hot cake for them. But for investors, any investment in excess of Rs 50,000 would be unproductive from the tax deduction point of view. As remains the question of investing in a large cap fund for wealth maximisation; closed ended newly launched RGESS funds score low on dependability when compared to some existing large cap funds which have a proven track record and lower expense ratio.

There is one more catch. Greed of 6% commission may also entice distributors to make exaggerated promises on the returns potential and even try to rope in some old investors to go for these funds, though they won't be eligible to claim the tax saving benefit. New investors are often less investment savvy and may solely depend on distributors for guidance. Although mis-selling and over estimation of return expectation of that extent is not possible under RGESS and their risk profile too being better as they being focused towards large caps; the possibility of such malpractices can't be completely ruled out.

Our View

The only way to increase the retail participation in Indian equity markets is to create awareness among people about equity as an asset class. An informed investor (who has the basic understanding of markets and is aware of the risks involved in equity investing), would be in a better position to deal with jittery market conditions that have become quite a frequent phenomenon nowadays. Luring an investor by offering tax deductions may not be enough to increase and sustain retail participation in equity markets. Unless the underlying investment delivers; tax incentives wouldn't make the first time investor a frequent investor. Exorbitantly high commissions of 6%paid to distributors wouldn't do any good. It may garner business for fund houses in the short term but wouldn't assure that the confidence of investors would stay with them in the long run.

Asset Management Companies might want to maximise their AUM under RGESS schemes and distributors might just want 6% of the amount they mobilised. In this entire process,high upfront commissions may entice advisors to opt for shortcuts and collect large sums from the limited investors.There is no upper limit on investment and investors being the first timers would be gullible. High commission may help garner more AUM but it may not necessarily broaden the investor base to a large extent.Would retail participation pick then? On the contrary, first time investors need an unbiased advisor who would help them identify role of such novel offerings in their investment portfolio and assist them in achieving their long term financial goals.

If you are novice to equity investment, or even if you are already investing in equity markets, you need to apply your senses and make well informed decisions if your advisor suggests you investment in newly launched RGESS eligible mutual fund schemes.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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