Why Taiwan’s new fund rules won't prevent “churning”

New rules are being introduced to stop Taiwanese banks from constantly shifting the assets of their investors into new funds just so they can earn additional fees.

Whether they succeed or not in altering such practices is another thing. Some fund industry insiders have their doubts. 

The incoming regulation, which becomes effective on January 1, aims to end what is known within the investment industry as “churning”. It’s a common tactic among many banks that distribute funds in Asia.

The salesperson gets paid a retrocession fee of several percentage points from the assets of every client they bring into a fund. And each time they switch client assets to a new fund, they can charge another round of fees.

However, some industry experts believe the malpractice will not go away simply because banks want to maintain their high fee earnings.

And that runs counter to the interests of high-net-worth and retail investors, even if it is sometimes  their own fault for having short-term mindsets and limited long-term investing discipline.

In order to help resolve any conflicts of interest between fund distributors and investors, the Securities and Futures Bureau (SFB) will stipulate that asset managers must not pay incentive fees for gross sales to fund distributors. 

As a result, fund distributors have to negotiate new contracts with asset managers before the end of the year, a spokeswoman at SFB told AsianInvestor in an emailed reply.

The aim is to encourage wealth managers to sell funds to investors that best suit their needs, reduce turnover rates for fund investments and also encourage asset managers to provide investors with better-quality fund services and investment returns.

It will be a "triple-win" for asset managers, distributors and investors, she said.

Fund distributors focused on creating high sales volumes are hurting investor interests, so starting from next year distribution fees will be calculated based on the assets under management (AUM) that they have outstanding, she explained.

For some seasoned market observers, the changes are long overdue.  

Local banks have been rampant in generating additional commissions via churning, Stewart Aldcroft, senior fund industry adviser at Citi in Hong Kong, told AsianInvestor.

Banks represent “a significant majority of the volume of funds” sold in Taiwan given the broad reach of branch networks across the island, according to a report released by Citi in March this year. And bank distributors have faced growing criticism over their churning habits.

CHURNING TO CONTINUE

Asset managers Cathay SITE and Nomura SITE, and bank distributor CTBC Bank all declined to comment on the new regulations when contacted by AsianInvestor.

But one general manager at a global fund house, who declined to be named, did tell us that Taiwanese bank distributors would likely find new ways to make up for the expected drop in fee income, not least because other parts of their business are struggling with low interest rates and weak loan growth.

Previously, banks have charged investors for handling fees as well as asset managers for incentive fees based on gross sales. Since they won't be able to charge asset managers any more once the new rules come into force, they will likely churn investors even more so they can receive more commission from them to make up for the shortfall, he said.

“Churning will not drop and there will even be more of it, especially in the equity fund space [because there are more movements in the stock market],” he said.

“Churning goes on anyway, it is often client- or investor-led, despite what you might hear from fund houses, because end-investors have never developed a longer-term attitude for mutual fund investing,” Aldcroft said.

Another possibility, according to the general manager, is that bank distributors will increasingly tend to promote funds that have so-called back-end sales-load structures, something echoed by consultancy Keystone Intelligence.

These back-end loads can be static or based in contingent deferred sales charges (CDSC). When a fund has static back-end loads, asset managers have to pay fund distributors a fixed fee that ranges from 1% to 4%. CDSC back-end loads are charges that decrease over time during a specified period (e.g. 4% in the first year, 3% in the second, 2%, then 1% in a four-year period).

“We heard that a few distributors now prefer to sell back-end shares in order to collect commission at once. In such cases, the fund houses need to pay upfront to meet the distributor's need, which can create financial burdens [for] the fund houses,” Donna Chen, founder and president of Taipei-based Keystone Intelligence, told AsianInvestor.

As of July-end, Taiwan’s mutual funds market had AUM totalling NT$3.49 trillion (US$111.4 billion) that were spread across 943 funds, data from the Securities Investment Trust and Consulting Association of the Republic of China shows.