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New Incentive Structure Needed in Mutual Fund Distribution Market
2021 Feb/02
New Incentive Structure Needed in Mutual Fund Distribution Market Feb. 02, 2021 PDF
Summary
It is the duty of mutual fund distributors to select and recommend products in the best interest of their customers. On another hand, however, those financial firms also have an incentive to act in their own interest to sell funds that would offer them the largest profit. Recent studies have found that conflicts of interest have actually arisen between financial product distributors and customers, and that this has undermined customers’ investment performance. To address the issue, several nations including the UK, the Netherlands, Australia, and South Africa introduced one after another a new policy for reshaping the market’s incentive structure, which would prevent financial firms from preferring a specific product to another for their own interest. Such a policy is worth considering for Korea as it is expected to bring about positive outcomes, for example, immediately addressing the issue of conflicts of interest between distributors and customers, facilitating competition between distributors, and enhancing customer access to low-cost products.
Do financial firms sell products for customers’ interest?

Publicly offered funds in Korea are mostly distributed by banks and securities firms. Although some of them are sold via smart phone apps, websites, and other online channels, a majority of customers still access to offline branches to see branch staff face-to-face for purchasing a fund product. As a result, larger banks or securities firms with more branches and customers tend to sell more products, and the funds recommended by those large players tend to attract a larger amount of investors’ money.
 
This leads to us a legitimate question: Do financial firms select and distribute mutual funds for their customers’ interest? They actually have an incentive to do so because under the law they are obligated to fulfill their fiduciary duty for their clients and to comply with the conflicts of interest principle because any breach of those will subject those firms to punishment such as fines or other punitive measures. On the other hand, a distributor of financial products is incentivized to select and distribute superb products for its customers who otherwise would shift to competitor distributors.
 
On the other hand, however, the fact that financial firms and the staff are pursuing their self-interest means the likelihood of conflicts of interest with their customers. For enhanced shareholder interest and higher employee remuneration, financial firms have an incentive to sell high-margin products or affiliate-managed products. Another incentive arises during everyday sales practices: Sales staff may benefit from recommending products serving their self-interest to their customers. In other words, it’s possible for a financial firm to recommend a less useful product even if there is another product that serves the best interest of their customers. 

Such conflicts of interest between customers and distributors could arise not only in publicly offered funds, but also in all other services and products. In most of those cases, those issues are addressed before growing to a serious problem as competition becomes fiercer among distributors, or as investors themselves choose more beneficial products for their own interest. However, this may not work well in mutual funds that are publicly offered for some reasons. First, there is a limited level of competition among mutual fund distributors. Price competition barely exists in this segment of market that is forced under the current regulation to set the same sales charge for funds with similar kinds. Furthermore, scarcity couldn’t be a strategy because the supply of most mutual funds—unlike privately placed funds and derivatives-linked securities—is not limited. In short, mutual funds distributors have virtually nothing in their hands to differentiate their products. Accordingly, mutual fund investors tend to go to a nearby branch or to reach a financial firm in which they already have an account, rather than trying to find a new distributor. Another reason is the difficulty for investors to find out whether a mutual fund is beneficial to themselves or not. Product information is available to everyone via a prospectus, a fund management report, disclosure, and other channels. However, processing such information for choosing a better product requires a substantial level of financial literacy and experience. This is because measuring the level of benefits each product has is a highly daunting task when it comes to mutual funds, unlike other ordinary services or products. 

Several recent studies have argued that conflicts of interest have actually arisen between mutual fund investors and distributors, and that this has undermined a substantial part of investor returns. Among others, Kim (2018) found a tendency where mutual fund distributors in Korea sell more high-fee or affiliate-managed funds, and also showed that the performance of those funds was relatively lower. Such an issue is not limited to Korea. Hoechle et al. (2018) confirmed, based on an analysis on the case of Switzerland, that financial firms acted in their own interest when recommending customers financial products, and that the customers investing in those products had relatively lower returns. All of those empirical results are reinforcing the need for the government’s further policy effort to address the conflicts of interest issue between customers and distributors. 


How can we deal with conflicts of interest?

The Korean government has exerted hard effort to address conflicts of interest between customers and distributors for a long period of time. The central focus of such policy effort has been on to create a neutral sales channel that is free from conflicts of interest. One of the primary examples is Korea’s Fund Supermarket, and the independent investment advisor regime. Fund Supermarket is designed to sell every mutual fund available in the market. Owned by a several number of asset managers and other financial firms, it remains neutral and thus free from any control by a specific firm. Alongside that, independent advisors are also purposed to give customers neutral investment advice because the advisors are banned from being affiliated with or employed by any financial product manufacturer or distributor, and from receiving any support that may wield influence on their advice. The problem is that such neutral distribution channels appear not to be functioning properly: Fund Supermarket established in April 2014 currently takes up a meager 0.6% in the mutual fund market, while no independent investment advisor has registered. In short, the policy effort has yet to pay off. 

To address conflicts of interest, overseas markets have more recently looked at how to reshape the current incentive structure so that distributors would not prefer specific products to others. More concretely, a fund distributor is banned from receiving any fees, commissions, or other benefits for fund sales from the fund, but is only allowed to receive them directly from the investor. Currently, the distribution fees from funds make up a substantial part of revenues in fund distributors. The level of distribution fees—which varies widely across individual funds—is determined by asset managers. For example, fund A may pay 1.0% of the sales outstanding to distributors every year, while fund B pays only 0.5%.  In that case, distributors have a higher incentive to sell fund A that is more profitable for their bottom line. If the distributors are banned from receiving sales charges from funds, then the sales margin would depend on other conditions than the contract with fund A and fund B. This could effectively remove the distributors’ incentive to prefer one fund to another, in other words, addressing the conflicts of interest problem.
 
It was the UK that has first banned the receipt of such benefits. As part of the Retail Distribution Review (RDR) that has been effective since 2012, the UK has outright banned all advisors and fund platforms from receiving any commission from fund managers. Since 2013, the Netherlands have also banned an investment firm from receiving or giving any inducements from or to a third party. Instead, investment firms could receive them directly from their customers. A similar ban forbidding a financial firm affecting retail sales from earning remuneration from a product manufacturer has also been implemented in Australia since 2013. After a recent amendment abolishing the exceptions, the ban began to be applied in full throughout Australia in 2021. South Africa also has enforced a similar policy since 2017. In the case of the EU, a discretionary portfolio manager is not allowed to receive any inducements from funds starting from 2018.1) This is because of conflict of interest concerns that could arise if the manager fills customer portfolios for its own interest.

The aforementioned policy direction is highly likely to produce immediate policy effects because it is trying to directly fix the incentive structure of distributors already dominating the market, which appears to be differentiated from Korea’s existing policy that is trying to address the issue by establishing a new sales channel. Also expected are some ancillary effects as follows. First, this could facilitate competition among distributors. Because one product could be sold at different margins, promotions and other price differentiation strategies will emerge, which will trigger fiercer competition. This will certainly benefit customers with innovative services at lower costs. Second, distributors will handle more low-fee products such as passive funds and exchange-traded funds that were rarely sold via bank counters due to their low sales margin. Distributors, if enabled to set their own sales margin, are expected to handle more of those products. This also helps satisfy customer demand for low-cost products that has been on the continuous rise. 

However, there are some aspects worth considering before shifting into the direction stated above. First, it is not that the aforementioned policy direction fully eliminates the issue of conflicts of interest because distributors still have an incentive to sell affiliate-managed funds. Second, there are other factors—handling of other retail products such as privately placed funds and derivatives-linked securities—affecting distributor’s incentive structure and conflicts of interest. Because this could halve the intended policy effect, there should be a thorough review on the impact. For example, it is worth analyzing the cases of the UK, the Netherlands, and other nations that have implemented the policy direction ahead of Korea to see whether they have successfully achieved the desired policy outcomes. As those nations are still discussing policy improvements, Korea should carefully monitor their development when formulating its own policy.
 
1) However, the receipt of inducements has been allowed for advisory and other intermediary services, except for discretionary portfolio management services. This could have reflected concerns that an all-out ban could make distributors in some markets sell their own products only, instead of diverse products of other firms (ESMA, 2020).


References

ESMA, 2020, ESMA’s technical advice to the Commission on the impact of the inducements and costs and charges disclosure requirements under MiFID II.
Hoechle, D., Ruenzi, S., Schaub, N., Schmid, M., 2018. Financial advice and bank profits.
The Review of Financial Studies 31(11), 4447-4492.

(Korean)
Kim, J.M., 2018, Analysis on the sales pattern and performance of the Korean domestic equity funds, KCMI Research Paper 18-04.