First, let's find out what did happen in Year 2005? New fund offers, a lot of them (about seventy-five) were launched. But what's wrong with that? Well, most of the NFOs had little to offer from an investor perspective, but a lot to offer to the distributor (commissions paid out on some funds were as high as 6.00 per cent).
The net result - distributors pushed the schemes to their clients, successfully. So, the fund house got the money, the distributor got the commission and you got the units. Of course the regulator, atleast initially, thought that this was a sign of a maturing investor class.
Since the fund house passed on the expense to you, it had nothing to worry about. The distributor made his commission (and also probably won a trip to Sun City, at your expense), and a lot of it - he was delighted! But you, the investor, were left with the burden of the expenses i.e. the bill.
If you are still invested in the aggressively marketed NFOs of 2005, expect the pain to last for five years; that's the period over which the NFOs' initial issue expenses have been allocated. Of course the incessant bull run will probably cover up this pain - what's an additional 2 per cent when you are earning 30 per cent per year.
But if you are a smart investor, you know this is hurting. If returns were to settle at a more realistic 15 per cent pa (per annum), you would be paying about 13.3 per cent of that just to reimburse the fund the issue expenses it incurred during its NFO period!
If you thought this was how all those involved in the transaction went about doing their business, you are mistaken. The distributors are a lot smarter. They not only pushed NFOs on you, and made exorbitant commissions, but they also 'churned' you.
What is 'churning'? The distributor gets you to redeem your investment in an existing scheme to invest in another scheme (usually both are equity-oriented schemes). Ideally, such a situation should happen when you are invested in the wrong scheme. But then if you were advised correctly in the first place, this scenario would not arise at all; and if it were to, it would be extremely rare.
But there is another reason for churning? When a distributor gets some money invested in an existing equity fund, he gets about 2.25 per cent of the amount as a one time upfront commission (the banks usually get a lot more; apart from that there are some non monetary benefits, which most distributors settle for).
The only other income the distributor will earn, if the client stays invested in a scheme for more than a year, is about 0.40 per cent pa (again, much higher for most banks and large distributors), post the first year. So the distributor has a choice - should he redeem the money to reinvest, in which case he earns about 2.25 per cent. Or should he ask the client to stay invested, which earns him about 0.40 per cent pa. For an unscrupulous distributor, the choice is obvious.
So, what's the best the mutual fund distributor came up with? He made you 'churn' in NFOs! Every transaction earned him about 6 per cent in upfront commissions!
The regulator finally got into the act and took measures to ensure that NFOs are no longer launched just to satisfy the needs of the distributor.
Just to put on record - In the year 2005 there were about 75 NFOs. Personalfn, which is also a distributor of funds, told its clients not to invest in 68 of the 75 NFOs. The other 7 were of course recommended to our clients selectively i.e. only in instances where the NFOs matched the clients' needs, were they recommended to invest.
Since April 2006, the mutual fund industry has to some extent been insulated from the NFO malaise. We do have NFOs still; but a lot less. In fact in November 2006 at one point in time there were five NFOs that were open for subscription. What was our recommendation to our clients? You guessed it right - do not invest in any of them.
But, don't you underestimate the genius of the unscrupulous distributor. He is now focusing all his efforts on churning your portfolio, even if it has to be in existing mutual fund schemes. A commission of 2.25 per cent may be lower than 6.00 per cent, but it's still a lot better than 0.40 per cent.
In our meetings with clients, especially those serviced by banks, there is some sort of a consistency - portfolios are churned about twice a year. Here's our advice to you - beware of your bank/distributor which is doing just this to you.
Remember, if the advice was right in the first place, where's the need to churn? Our view on banks getting into mutual fund distribution is clear - they are hurting the investor and the industry. All they do is push schemes onto unsuspecting investors (for all those who have ever walked into a bank branch, the experience is unforgettable!).
This holds true for most banks in the country. Don't believe us? Talk to the investors being serviced by some of these unscrupulous banks!
There is one other point that needs to be touched upon here. Apart from the commission that is paid out to the distributor, there are also other benefits that are provided - gifts, holidays and what have you.
So even though upfront commissions are lower, if you factor in all these other costs (will ultimately reflect in the expense ratio), you are still paying quite a bit. Our advice - ask your distributor on the non-cash benefits he/she receives from the AMCs. This will help you evaluate the advice better. At Personalfn we do not accept any gifts/benefits from the fund houses that are beyond the published rate of commission.
For a Free download of the latest issue of Money Simplified - The 2007 Guide to Tax Planning, Click here!
More from rediff