Table of contents
In the financial services sector, commissions are a crucial part of the compensation for brokers and financial advisors. Investors must know and understand the types of commissions to make wise decisions for their investment returns.
Upfront and trail commissions are among the many commission models often referred to. This article aims to illustrate how these two types of commissions differ as far as both investors and financial advisors are concerned.
Also read: Understanding the basics of the broking industry and its recent trends
Understanding commissions
Commissions are fees that a broker or investment adviser charges their clients for providing them with financial advice or for carrying out sales and purchases of securities.
Many full-service brokerages earn substantial profits by charging commissions for conducting transactions on behalf of customers. The commission rates charged by each brokerage typically vary from those of the others, indicating the fee schedule that each used to bill for different services.
When calculating losses and gains associated with selling securities, it is necessary to consider the impact of commissions, as this will provide an accurate valuation.
Upfront commission
When an investor purchases a mutual fund scheme, an asset management company (AMC) pays the distributor an upfront commission.
For instance, if an investor buys mutual funds worth ₹100,000 at a 2% upfront commission, the advisor gets ₹2,000 immediately.
Advantages of upfront commissions:
- Encouraging immediate compensation for advisors to sell products
- Fee structures are also simple to calculate and understand
Disadvantages of upfront commissions:
- There might be conflicts of interest when advisors prefer products with higher initial commission rates
- The investors may face significant initial costs which lower invested amounts
In 2018, the Securities and Exchange Board of India (SEBI) prohibited mutual fund distributors from receiving upfront commission payments.
According to SEBI, there is no longer room for an upfront commission or upfronting trail commission in distributor payouts. In its place, the industry must move towards a model where commissions are based purely on trail commissions.
Must read: SEBI’s quasi-powers: Keeping India’s securities market ethical
Trail commission
Trail commissions, otherwise known as trailing or renewal commissions are a continuous fee that is paid to an advisor while this investment is still being held. Normally, these commissions are typically small percentages of the investment value and are paid periodically, for example, annually or quarterly.
For example, if a mutual fund investor has ₹100000 in assets with an annual trail commission rate of 0.5%, the consultant will earn ₹500 per annum for the duration of ownership.
Advantages of trail commissions:
- It aligns the interests of advisers with investors’ long-term success
- It also encourages advisors to provide ongoing service and support
Disadvantages of trail commissions:
- Over time, there may be substantial long-term costs for investors.
- Advisors may concentrate on preserving current investments rather than recommending new opportunities.
Difference between upfront and trail commission
Here’s a concise table summarising the key differences between upfront and trail commission in mutual funds:
| Aspect | Upfront commission | Trail commission |
| Definition | One-time payment to the distributor at investment | A recurring fee, paid as long as the investment remains |
| Payment frequency | Paid upfront during investment | Paid annually until withdrawal |
| Calculation | A fixed percentage of investment | Based on the total investment brought by the intermediary |
| Incorporated expense | Not included in the expense ratio | Included in the fund’s expense ratio |
| Focus | Short-term transactional | Long-term relationship and service |
| SEBI directive | Eliminated by SEBI | Encouraged solely trail commissions |
Impact on investors
Once, deciding between upfront commissions and trail commissions had been an important decision for investors, but after SEBI’s directive of 2018, only trail commission remains. Implicitly, the modification has a big impact on how commissions gradually affect an investor’s portfolio.
- Long-term returns: Compared with other funds with high entry charges, trail commissions may seem insignificant initially; however, such deductions can have a significant cumulative effect for someone who invests for long periods.
The portfolio can give up some of its total returns since it is subject to annual reductions in value. A trail commission amount also grows if the investment does, thus weighing down on the portfolio’s performance.
- Behavioural incentives: Trail commissions are tailored towards achieving long-term success for the investor and advisor since they receive remuneration that correlates with continued growth and retention in their investments.
Long-term gains are prioritised over short-term sales, leading to improved investment decision-making processes.
You may also like: Behavioural finance: Understanding the psychology behind investment decisions
Bottomline
The shift from upfront to trail commissions represents a positive evolution in the financial services industry, prioritising the long-term interests of investors and fostering a more transparent and sustainable advisory relationship.
Understanding these commission structures as an investor will help you make better decisions and make sure that your investments are managed to meet your long-term financial objectives.
FAQs
Trail commission is earned on the persisting worth of the holdings of an investor in a given investment product, which is mostly a mutual fund. The commission is computed based on a fraction of the investor’s current net asset value (NAV) under her management (AUM). It is made at intervals, regularly yearly or quarterly to the distributor or adviser as long as the investment remains with them. It encourages advisors to uphold enduring client relationships and enhance investment performance.
A trailing commission aims at motivating financial planners and distributors to continuously offer assistance and guidance to their customers. Advisors are, therefore, interested in receiving payment depending on how much clients continue putting into an investment with them. It links both parties’ incentives, making sure that there is regular supervision and control of an investment portfolio.
The trail commission is paid to the mutual fund distributor as long as the investor has his or her investment in that company. This type of commission is usually calculated according to the value of the investor’s assets under management at present and is often paid either annually or quarterly. The payment continues until the investor cashes out or sells off their investment in a mutual fund.
Mutual fund distributors (MFDs) cannot generally sell portfolio management services (PMS). PMS is another investment product that requires separate licensing and registration with regulatory authorities like SEBI in India. While MFDs specifically focus on distributing mutual funds, PMS services are usually provided by Registered Investment Advisors (RIAs) or entities licensed solely for providing PMS. Consequently, MFDs must fulfil the requisites to deal legally with PMS offerings.
Choosing between portfolio management services (PMS) and mutual funds (MF) depends on what an investor wants. While PMS offers personalised portfolio management designed for individual goals and risk appetites, it needs higher minimum thresholds of investments compared to other products hence high costs incurred too. Conversely, mutual funds offer diversification, liquidity, and professional management at lower levels of entry among others.