|»5 Minute Wrap Up by Equitymaster|
On This Day - 13 OCTOBER 2014
Is mis-selling of Mutual Funds about to end?
In this issue:
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.
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.
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
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