Why your fund distributor wants you to keep shifting between funds
Find out the hidden cost behind churning your mutual fund portfolios
Well, this email is a blast from the past, isn’t it?
Apologies for having been away for more than a year at this point. Life just gets in the way at times. Hopefully a monthly publication is something which happens here on out!
Moving on to the topic at hand.
While there have been repeated posts highlighting the level of wealth leakage that happens if someone were to stick to a “Regular” mutual fund rather than a “Direct” mutual fund, below is another reminder in case you have missed it so far.
But let’s face it.
For a few people who find their time is better worth on their work, rather than understanding these differences, would want to stick to a “wealth advisor” or a “portfolio advisor” or a “financial doctor” (or whatever is trending these days), who seemingly provide services “free of charge” to customers and help them pick mutual funds.
At the risk of repeating myself, (for the Nth time) these advisors are technically Mutual Fund Distributors (MFD) who earn a commission from the fund that is recommended by them to a retail investor.
While SEBI has taken steps, to improve transparency for innocent retailers, the Asset Management industry finds a way. Here is the latest trick up their sleeves.
But first!
How did SEBI improve fund commission structure:
More than 10 years back, SEBI already came out with regulations to abolish Entry Load.
Entry load, is a % charged by fund houses to cover the cost of distribution and is deducted from the amount invested.
Simply put, if you put 10k in a fund with 2% entry load, only 9,800 makes it to the fund and 200 is split between the fund and the distributor.
Entry load used to range at about ~2.25%, when it was prevalent, but not anymore.
So Entry load going away was a good thing, right?
Absolutely.
SEBI’s objective behind abolishing of entry load was a welcome step, but that doesn’t make it impossible to gain at cost of innocent retailers.
Here’s the latest gimmick.
Attached below, is a screenshot of commission structures for a few schemes for ICICI:
See how the commissions are on the higher side for 1st year and go on decreasing?
You should start to smell what MFDs might do from here.
The Gimmick:
Say you’re an investor in a scheme of HDFC for a year which hasn’t done that well in about a year.
In comes your MFD, mentioning how the HDFC’s scheme has deteriorated and is not a good long term investment (which he himself recommended, mind you).
Now the MFD will start singing praises of some other ICICI fund which would have done well in the past and how it is the “next best fund”.
Suppose, one were to fall for this and move money from HDFC to ICICI, do you see what happens?
The MFD gets the high 1st year trail commission for HDFC. Then in Y2, when the trails are supposed to come down, the MFD switches to another fund which would be a Y1 fund, thereby requiring higher 1st year trail commissions.
Voila. Your MFD will earn a sizeable gain in the process.
Why does this work:
While it is quite obvious now why the MFD wants this, why would the investor agree to this?
For an investor, he is concerned about returns. When the MFD himself comes up and tells him that the fund has underperformed and another fund will outperform going ahead, the investor would probably not be aware about the trail commission structures which are still skewed towards the higher side for Y1, and think might as well just shift the funds to get better returns.
And of course, let us not underplay the hand of FOMO in all this.
Let’s face it. The way an average investor picks a scheme in India is based on “Last 1 year performance” (“Last 3 year performance” if they consider themselves slightly more sophisticated).
Bottom line: Investor sentiment for average investors is driven by what happened in the past.
My 2 Cents:
If you are someone who doesn’t know about these things at length, pick a simple direct passive fund that replicates the performance on Nifty itself. In the long run, having market returns will be worth it paying higher commissions for active funds.
Even if you are new to markets, allocate 70-80% via passive funds and take risk on stocks you study with the balance 20-30%. Allocations in future can change based on your own confidence in the stock picking process.
PS: I in no way mean to imply that all MFDs would pick antiques like this and encourage churning of client portfolios for their own selfish reasons.
PPS: If you haven’t already, do consider checking out my IG where I am relatively more active and which cover less serious market posts (aka memes)