Have you ever wondered why your relationship manager is always eager to recommend buying an equity or balanced mutual fund scheme and rarely recommend switching to debt mutual funds? Did it occur to you why the new fund offers (NFOs) with no track record are pushed while schemes with similar objective and verifiable track record are ignored? Why are close-ended funds peddled when the investment objectives can be met by open-ended funds with an option to redeem at any point in time? The answer to all these questions could be the Conflict of Interest.
Although the malpractice is rampant in the insurance industry, many investors have already realized this after making poor returns or significant losses on their investments in insurance-linked investment products. For the investors who have realized that insurance and investment need to be separated, should take a step forward in optimizing their returns in mutual funds.
Conflict of interest between your objective to optimize your returns and distributors desire to earn higher commissions not just undermine but could ruin your investment returns and financial security. In this piece, we would focus on why conflict of interest exists, how it is not good for investor’s interest and how to avoid it.
Why conflict of interest exists?
To understand this, one has to understand the evolution of the mutual fund investment industry. In advent of the institutional management of investment money in equity and debt markets, agents/distributors were appointed to sell the products i.e. mutual fund schemes to prospective investors. In return agents/distributors used to get the commission from the money collected by selling these products and a perpetual trail commission till the investment is outstanding.
This was an appropriate arrangement in times when there was a lack of awareness regarding mutual fund investments and there was a limited number of categories & schemes to select from.
Fast forward to the current times, the investment community has matured and there are more than thousands of mutual fund schemes available for investments. Every equity, debt or hybrid mutual fund scheme has a different commission structure (upfront and perpetual monthly trail) attached to it, varying across different schemes and different fund houses.
Thus for a distributor, it has become a battle of conscience. He can either enhance his earnings by selling schemes with higher commission but having poor suitability to investor’s objective or he can reduce his earnings by selling better performing schemes suitable to investor’s objective. In this tug of war, unfortunately majority tends to focus on putting their own interest ahead of the investor.
How is it not good for an investor’s interest?
Every investor has a different investment objective that primarily depends on his financial goal, risk profile, time horizon, liquidity needs and taxation. That means every investor needs a different set of investment mix to suit his/her investment objective. However in the greed to earn higher commissions, the fiduciary duty towards the investor is often ignored.
Products generating higher commissions are sold by maneuvering or deliberately hiding important disclosures to push it in the investor portfolio. This is the precise reason why many investors are sold close-ended products, NFOs, poor performing schemes and balanced schemes with the lure of regular dividends.
In the last few years, many risk-averse investors were sold balanced funds with a promise of regular monthly dividends higher than FD returns. If these investors were told about the possible loss of principal and possibility of discontinuation of dividends, many would have backed out.
Everyone understands the principle of buy low and sell high. However, very few distributors would recommend investors to sell equity and move to liquid funds when markets are at peak valuations. Usually, liquid funds/ultra short debt funds earn a lower commission for distributor compared to equity funds.
Thus there is reluctance in re-balancing the portfolio towards safety during expensive market valuations. Rarely a distributor would advise you not to invest in mutual funds with equity exposure on the back of expensive prices.
The problem also lies with many bigger institutions which incentivize their employees for fresh investment mobilization on monthly basis. The employee thus is mostly engaged in selling products to generate target commissions than managing the existing investments that he/she has already sold to an investor.
It is important to understand that investment is never a one-time activity. It requires constant hand-holding, behavior management, tweaking and re-balancing the portfolio with a change in market dynamics and the investor’s own situation.
How to avoid conflict of interest?
Assessing the prevalent practices in the investment community that goes against fiduciary duty towards investors, SEBI took a commendable step in 2013 by introducing Investment Advisers Regulations and Direct Plans in mutual funds.
Investor Advisers regulations defined two intermediaries between the product manufacturers and investors – one being an Adviser (who needs to be registered with SEBI and are called Registered Investment Advisers (RIAs)) and another Distributor. Like a doctor who charges fees for his services, an adviser also earns fees for investment management and advisory services.
On the other hand, a distributor like a chemist can earn through the commissions from the products (schemes) sold by them. For now, a distributor may offer incidental advice on the mutual fund schemes but this is under discussion at SEBI.
If a distributor is paid by the product manufacturers i.e. mutual fund companies and not by you, then you are not the client of the distributor in the true sense. A client is the one who pays for the services. In this case, the client of distributors is the mutual fund company that pays the distributors for their services of bringing your money. If you are getting something for free, then you are the product.
Your best bet to avoid conflict of interest is to engage with SEBI RIA who is barred from earning commissions. SEBI RIA would ideally recommend and manage investments in zero-commission Direct Plans of mutual funds. When your money is invested in direct plans of mutual funds, your returns increase by up to 1.5% per annum compared to traditional regular plans due to lower expense ratio of direct plans.
Higher returns in direct plans and conflict-free investment management would help in enhancing the overall portfolio returns. Part of the additional returns can be paid as advisory fees to the RIA for the services rendered by him/her.
Now tell me, would you prefer going to a doctor who doesn’t charge you fees but gets paid by the pharmaceutical companies of which he recommends medicine? Of-course not.