A Shade on Mutual Fund Distributors
Commissions, commissions, commissions.
A few years back, I was working in a Portfolio Management Service (PMS). It was a small firm and one of my least favorite parts of the job was handling relationships with the distributors. Talking with them on a phone call was so draining, I avoided them like I avoided my toxic ex.
The Distribution Game
PMS and AIF distributors are not much different from mutual fund distributors.
My conversations with these distributors revolved around the same thing. Increase their commission rate. Everyone wants a 50% sharing rate. 50% of what the PMS or AIF earns from the client. If the PMS/AIF charges say a flat 2.5% fixed fee annually - distributors at 50% sharing, get 1.25% of the client's AUM as commission. Whatever the PMS earns from the client, the distributor gets a cut - year after year.
On these phone calls, it was pretty common for the distributor to make some thinly veiled backhanded threats. Diplomatically of course.
'Oh, we can't work with a 35%-40% commission rate. This PMS gives us 60%, and your performance is not much different from theirs. How do you expect us to push your product to our clients?'
We both knew no one gives out 60% unless it's an underperforming fund. I would call them out. Diplomatically of course. We would haggle. Lots of back and forth. And it usually ended up with me wondering, why am I working in this industry?
At least, most customers didn't believe all the BS these PMS/AIF distributors threw at them.
But the same cannot be said about the MF distributors though.
Mutual funds distributors are no different. They want more commission. They haggle crazy. And they can sell.
There is nothing inherently wrong with commissions, we all want more money. But the commission is an incentive here. And...
Incentives Drive Behavior
“Show me the incentive and I'll show you the outcome.”
—Charlie Munger
MF distributors often deal with the unsuspecting retail public. Our local small-town agent comes to our house once every 6 months, sips chai, and pesters my dad to invest in this amazing new fund that has launched recently. Say what you will, these people are the best salesmen one could see. Or if you prefer the more corporate term, the best relationship managers one could see.
It doesn't end with mutual funds though. They also want to sell my dad different insurance schemes as well. If you ever wondered why ULIP is so popular, just watch my small-town agent uncle sell them.
Even a good chunk of my educated, smart, corporate-working friends have no clue about mutual funds. They know mutual funds sahi hai, and one should do SIP. But apart from that, they don't have much clue. They don't know what is a Direct fund vs a Regular fund.
(Side note: Direct funds are when you invest directly into the fund. Regular funds are you are investing through a distributor. Obviously, Direct funds have a lower expense ratio (management fees) since they don't have to pay your distributor).
Active mutual funds provide anywhere between 0.5% to 1.5% commission (of the AUM) to the distributors. Many distributors rue the time when higher than 1% commissions were the norm. The good old times when every active MF charged a management fee of around 2.5%.
These distributors won’t pitch you the best funds. But the funds that make them the most money. The one that gives them the highest commissions. There is a reason why these distributors rarely, if ever, ask you to invest in index funds.
Some smart distributors pitch multiple funds and club the best funds with the best commission funds.
Now, I don't want to paint the entire industry in broad strokes. There are some good distributors, who have a reputation to maintain and play the long-term game. They compromise on the commission rates to build client relationships lasting years, even decades. These kinds of distributors are not the norm though. And overall, it's not an honest industry.
India's Fintech Boom
For quite a long time, even the online platforms that recommended mutual fund schemes weren't much better either. Many of these online platforms were themselves distributors. Sure, you didn't have to deal with a distributor salesman anymore. But the funds that appeared at the top were by no means coincidence. And often not the best ones.
However:
With the influx of VC money into fintech, things have changed for the better. There are lots of platforms offering direct mutual funds investing now. Yup, no more Regular MF that chips away your money and gives it to the distributors. Also, SEBI and AMFI are pushing for more transparency as well.
You can invest in direct MF schemes through these online platforms. And they are not selling you some underperforming funds since they don't get any commissions. I am not sure how these platforms are going to make money (hopefully the advisor route, not the distributor one), but for now, it's good for the customer.
There are lots of platforms that you can go for. Just check whether these platforms offer direct funds. If they are, you are good to go.
Few Pointers On MF Investing
To wrap up, here are some pointers. While this is by no means a comprehensive guide, here are the basics you need to know about MF investing:
Always go for Direct funds. (You see Regular, you say No).
Cut the distributor and do your research. There are lots of websites that provide info on MF schemes. A few of them - ValueResearch, Moneycontrol, RupeeVest, ET Money. (Use these sites for research only).
Check the fund's historical returns. Ideally 5-year or 10-year returns, at the minimum, 3-year returns. The fund is less than 3 years old? Avoid. (If you know your mutual funds and a trusted fund manager is starting a new scheme and you want to invest - go for it. But for beginner investors - new funds are best left alone).
AMCs are different than funds. Each AMC can have multiple funds. So ignore AMC and treat each fund as a standalone one. (For example, HDFC Midcap fund, HDFC Flexicap fund, and HDFC Top100 fund - all are from the same AMC, but all 3 are different funds with different fund managers and performance).
Number of MFs to invest in? I prefer 3 to 5 funds. More than 5 - too many and you will lose track. Only 1 or 2 funds - you are too concentrated.
Split between active vs passive MFs? I like it as - 2 index funds, and 2-3 actively managed funds.
Split between market cap? I prefer index funds for large-cap and active funds for small and mid-cap. With one active Flexicap fund (yup, the popular one).
To reiterate, go for Direct funds always. I go for Direct-Growth, but Direct-IDCW is fine as well.
Disclaimer: Nothing written here is investment advice.
Nice read. Thanks.
Two questions:
- Is it worth switching the funds if one is underperforming?.
- What are your views on goal based investing?. One mutual fund for each goal?.