Is mis-selling of Mutual Funds about to end?

Oct 13, 2014

In this issue:
» Will falling crude prices help to contain the CAD?
» Why time in the market is better than timing the market
» Mountain of debt is in the way of fast project clearances
» Is global trade in the 'new mediocre'?
» ....and more

At Equitymaster, we have cautioned investors time and again about mis-selling in the financial industry. Be it banks, insurance, brokerages or mutual funds; unethical practices have infected all areas of finance. Think about it. When was the last time an insurance agent spoke to you about the amount of life cover that you really need? He would have been more interested in pushing the latest ULIP with the fattest commission.

The same story is sadly true for the mutual fund industry as well. Until not so long ago, mutual funds were allowed to deduct a percentage of your investment; (called an 'entry load') to pay upfront commissions to agents. This led to wide spread mis-selling in the last bull market. In the mad rush to garner assets, investors were sold risky funds (like thematic and sector funds) that were not suitable for their risk profile at all. We all know what happened as a result of this. When the bull market ended in 2008, these funds were the worst hit. Retail investors simply cashed out of these funds as the markets recovered. They wanted no more of the equity markets once they broke even on their investments.

SEBI had banned entry loads in August 2009. However, this did not end the menace of mis-selling. Ever since the ban came into effect, MFs have paid agents upfront commissions from their own pockets. This was not seen to be much of a problem while the markets remained subdued. However, with the markets scaling record highs, mis-selling has returned in a big way. Consider this question: Do you believe that your relationship manager at your bank will have your best interests at heart, if he gets 6.5-7% commission to sell you the latest closed-ended mutual fund? Well, this is exactly what banks are getting right now. We won't be surprised if you have already been approached by your RM to invest in such a fund.

Thus, it is heartening to note that things might be about to finally change for the better. The Association of Mutual Funds of India (AMFI) has proposed that asset management companies should scrap upfront commissions. If this is implemented, it would be a hugely positive step for investors. Under this system, agents will be paid over the period of time that an investor chooses to remain invested. This will force agents to sell equity MFs as long-term investments. This is exactly how they should be sold.

However, we will not celebrate just yet. There is a long way to go for the industry to clean up its act. Our founder, Mr. Ajit Dayal has repeatedly highlighted the extent of mis-selling in the industry. He has also founded Quantum Mutual Fund which is India's only asset management company that does not employ any agents. This direct-to investor business model has enabled Quantum to charge a low expense ratio (compared to the industry average) to its funds. Investors naturally benefit from the lower expenses. Over the long term, if two funds earn the same returns from their equity investments; investors will be much better off in the fund with the lower expenses.

Will we soon see this happening across the industry? We certainly hope so. Investing in equity markets (via mutual funds) can create long-term wealth for domestic investors. This opportunity should not be undone by mis-selling. The sooner equity MFs are treated as long-term investments by agents (due to the removal of upfront commissions), the better for retail investors we believe.

Will the end of upfront commissions lead to the end of mis-selling? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Falling crude prices have a lot of ramifications for a country like ours. And most of them good. Thus, with Brent crude down to US$ 90 or so levels, and the global supply demand dynamics moving towards oversupply, many positives are in the offing for our economy. Lower losses on selling fuel below cost for our oil marketing companies and a reduction of inflationary pressures are two of the most immediate. But if crude prices continue to remain at lower levels, India's current account deficit too is expected to see a huge improvement. We present today a chart showing projections of the current account deficit (CAD) for India based on various levels of average Brent crude oil prices for the current financial year and the next. As can be seen, our current account position is highly sensitive to the level of oil prices. Thus, prices falling further from here on are likely to give a much needed boost to the economy.

Falling crude prices positive for India

Warren Buffett is arguably the biggest evidence that stock markets aren't efficient after all. However, the Oracle of Omaha is himself of the belief that an average investor should not go about exploiting this inefficiency. On the contrary, there's a better way out there to get assured long term returns without taking those unnecessary risks. And this method answers to the name of passive investing. Yes, that's right. Study after study has shown the virtues of merely remaining invested in the markets for the long term and having a disciplined and systematic way of investing. It has in fact turned out much better than majority of the investment strategies out there.

Reasons for this outperformance are not hard to find. Active investing entails significant costs in the form of commissions and short term taxes. And while these differences could seem small over the short term, they indeed matter a lot over a longer timeframe. Besides, we humans suffer from what is known as the overconfidence bias. This then leads to erroneous analysis and makes us move in and out of the markets at precisely the wrong times. Consequently, it makes much better sense to let the power of compounding do its work and stay away from those unnecessary frictional costs. After all, even Buffett wants his Berkshire cash to be invested in a passive index fund after he is gone.

During the boom period most Indian banks lent huge money to the power and infrastructure sector. However, later they saw their loan books turning bad. But RBI came to their rescue and allowed them some grace period in the recovery process rather than directly classifying such loans as bad. A direct NPA classification would have led to higher provisioning and profitability would have taken a big hit.

However, banks are now facing another headache as the grace period is about to end within next 6 months. Post that, they will have to take losses on these loans. Hence, all large banks as well as power and infra firms to whom the money was lent are trying to find a quick solution to come out of this mess. If not, bank's books will start reflecting losses from these stuck projects.

While it is true that Indian banks are more conservative than their foreign counterparts and it was policy flip flop that hurt their asset quality, one cannot deny that most of them went overboard when it came to financing infra projects. As an illustration, bank's exposure to power sector has doubled from 2008. Thus, it would be interesting to see how they come out of this self inflicted trouble. We reckon 6 months is too short a time frame to solve this malady. Hence, most probably the asset quality of banks will worsen in FY16 as most of them will start booking losses on junk loans

For over two decades before the financial crisis of 2008, the global economy had thrived on international trade. This was triggered by the opening up of major economies such as Russia and China. The emergence of the global supply chain linked factories in emerging economies to the affluent Western economies. During this period, international trade grew twice the rate of economic output. But it seems that international trade is running out of steam. The obvious reason is that the Chinese economy is slowing down after decades of gravity-defying growth. Rising wages in China also mean that it is slowly losing out the cost arbitrage that it enjoyed for so long. As per McKinsey Global Institute calculations reported by Reuters, trade and cross-border financial flows account for up to one-fourth of global growth. So if global trade is about to slow down, then the global economy may have to come to terms with sub-par growth for an elongated period.

In the meanwhile, the Indian stock markets pared losses but continued to trade below the dotted line in the post noon trading session. At the time of writing, BSE-Sensex was trading lower by 29 points (0.1%). Majority of the sectoral indices were trading in red with realty and FMCG stocks being the biggest losers. IT and metal were among the few stocks trading positive. Barring Hong Kong, all the Asian stock markets were trading in the red with Taiwan and Japan being among major losers. Even the European markets have opened the day on a weak note.

 Today's investing mantra
" A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest." - Warren Buffett

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3 Responses to "Is mis-selling of Mutual Funds about to end?"

Aruna Murdia

Oct 13, 2014

MF Entry Load---An eye opener that how these agents fleece investors. They don't have the investors interest in their mind but they want to meet their target so as achieve their goal and win a trip abroad, promotions or raise. Why fund houses can not state the upfront commission paid to the agent in their red hearing book or better state the same on the application form . This will make the system more transparent. Hope SEBI look in this matter



Ganapathy Sastri

Oct 13, 2014

Mis selling will continue in one form or another. SEBI had stopped MFs from levying ENTRY LOAD. MFs have started charging EXIT Loads even for debt funds for which earlier there was no entry load or exit load. Loot of the customer continues and will continue.
What is the need to offer CLOSED ENDED MFs? There is a plethora of open ended MFs in the market in every category: equity, debt, liquid etc. The only reason to offer CE MFs is the rewards MF houses get. A closed ended fund is classic case of "HARD EARNED MONEY GETTING HARDENED". There is absolutely NO LIQUIDITY despite the closed ended fund being listed. Listing of such funds is a sham and it is a shame regulators are turning a blind eye. If any thing there should be a moratorium on starting closed ended funds.


SJ Mariadas

Oct 13, 2014

When the entire "exchange" is rife with insider trading and market manipulation, why should only the mf mis-selling end which is only a small part of that industry!

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