It is a strange world! Not everything is subject to reason. People usually are quite savvy and materialistic when it comes to money. However, the preference to pay crooked mutual fund commission on their mutual fund investments over fees baffles me! Perhaps, there is some deep underlying psychology to it!
(We consider fees as a simple straight charge; commissions are ‘crooked’ only because the money goes from you, the investor to the Mutual Fund, and then to the broker: not a ‘straight’ flow! No need to attribute any other meaning to that word).
What is the issue about?
Let us first understand the issue. I am essentially talking about preference of investors for “regular” mutual funds when compared to “Direct” mutual funds. Regular readers of this blog would have by now understood that there is no difference between the two variants of the same fund, except that in case of a Regular Fund, a commission is paid to the broker or advisor assisting you with the investment, whereas in case of a Direct Mutual Fund, there are no commissions paid to the intermediary. Hence, no broker sells you Direct Mutual Funds. Platforms such as Jama offer “Direct” mutual funds, but charge some fees from the investor.
Straight Fees Vs Mutual Fund Commission
Earlier blogs have clearly highlighted that commissions are nothing short of daylight robbery. The fee is paid one time, or in the case of regular investors, once a year if an investor decides to renew his subscription. In contrast, Commissions are paid for as long as the investor is invested in the mutual fund.
The fee is usually flat. The amount of fees charged by an investor should not differ whether an investor is investing RS.5,000 or Rs.50,000 or Rs.50 lakhs unless the nature of service provided is different. In contrast, commissions are calculated by applying a percentage to the amount invested. Typically, broker commissions are in excess of 1% of invested amount. So, if an investor invests Rs50,000, she pays Rs.500 as commission while this amount is Rs.50,000 if the amount invested is Rs.50 lakhs. The additional effort put in by the broker to earn this extra Rs.49,500 is to write two zeroes extra in the application form!
For example, an investor investing Rs.50 lakhs through Jama, if she is not opting for personalized service in terms of goal based portfolio allocation, pays only a one-time subscription of Rs.499. However, she will end up paying in excess of Rs.50,000 year after year to the broker, if she opts for Regular Mutual funds.
Thus, it is a no-brainer that direct Mutual Funds should be our preference over Regular mutual funds.
Industry Practice
It is shocking to note that more than 90% of investments continue to be made in Regular Mutual Funds. There is hardly any interest in search engines for “Direct” mutual funds. SEBI, the Capital market regulator made it compulsory for all Asset Management Companies to offer “Direct” plans. It has been running quite a few investment campaigns urging investors to choose Direct Funds. SEBI Registered Investment Advisors are prohibited from selling Regular funds. Yet, Regular Mutual Funds still have such a large share of the market.
So much that, Asset Management Companies such as Quantum Mutual Fund, which had taken a stand that they will offer only Direct Mutual Funds, are now giving the investors the option of investing in their “Regular” mutual fund versions. In other words, they too want the distributor’s help in pushing their fund. Howsoever reluctantly, they too have now agreed to pay commissions to brokers, although the commission percentage is extremely small.
Another reason could be that with more online distribution channels available for people to buy mutual funds, they don’t want to be excluded (or blacklisted) from the party. They may not wish to pursue brokers the way many other Mutual Fund companies do, but Hey, why not increase the Assets Under Management and thereby pass on the benefits of reduced expense ratio to all of their investors?
The Online Picture – Who is searching what?
Speaking of online digital distribution of mutual funds, there is a snapshot of what Google searches on Mutual Funds vs Direct Mutual Funds are showing in India. We will cover the headlines only here.
1. “Mutual Funds” Searches are Growing
Thanks to demonetization there was a significant bump in the popularity of ‘Mutual Funds’
2. “Direct Mutual Funds” Searches are Growing Much Faster
The growth curve here is steeper, also due to the fact that the base is small. The demonetization bump up has lasted longer.
3. Comparatively, Direct Searches are lesser but growing fast
The red line is picking up and will reach the 25 line in a couple of years as per our prediction.This third graph is also the reason behind this post, to probe the psychology and also help people migrate to direct plans.
Why do investors prefer “Regular” mutual funds?
Lack of Awareness:
One reason could be a lack of awareness. Most investors invest through Brokers, Banks or IFAs (Independent Financial Advisors), who sell Regular funds only, as the commissions are very high. However, it has been more than 3 years since the launch of Direct Mutual Funds and there is a lot of push from the Regulator. I personally know investors who are aware of Direct funds but willfully choose Regular Funds.
Service provided by Broker
The friendly broker/ banker/ IFA will come to your house, advise you on the “best” funds to invest in, fill up the forms, submit it, give you the acknowledgment and do practically everything except signing your cheque and application form. Investors probably do not mind paying a small amount of 1% for such “Value-added” services. If that is the case, why is the investor not comfortable paying a fee, which is much lesser than the 1% paid to the broker, to a RIA or to a platform like Jama?
Relationship
Another reason why “Regular” funds are preferred over Direct funds is that Investors value their “relationship” with the broker, banker or IFA. The “broker/ IFA” is just like family. He/She is the “go-to” person whenever we are in doubt, he/she has always been around, etc could be some reasons you would hear from investors. However, the same relationship gets sour if the IFA becomes a RIA and asks for a small fee for the services provided.
Where is the Math going wrong?
I feel the reason why investors consciously choose regular funds over Direct Funds is because of the faulty understanding of how commissions are paid. Investors who have been investing in various types of investments such as Post Office schemes, Government Securities, and Corporate Bonds, as well as Initial Public Offers of various companies, are aware that the broker gets his commission. However, in all these cases, the commission is paid by the issuer. For example, if you buy an NSC certificate from Post Office by investing Rs.10,000, whatever commission is paid on the same is paid by the Post Office and not by the investor. The investor’s investment amount remains Rs.10,000. Thus, the investor perceives the services obtained from the agent as “free” for him/ her, the commission being paid by someone else who needs the money. Hence, the investor does not grudge the commission earned by the agent. However, fees is paid upfront by the investor. Why should the investor pay something, when the agent is anyway getting the commission from the issuer?
It must be understood that it does not work the same way in case of mutual funds. When an investor invests Rs.10,000 in a Mutual Fund Scheme, which charges hypothetically 1% TER (Total Expense Ratio), then that 1% (or Rs.100 in our example) is deducted out of Rs.10,000 invested by the investor. In other words, only Rs.9,900 is invested and the returns earned by the investor will be only on Rs.9,900 and not on Rs.10,000. Thus, the issuer, in this case, the Asset Management Company, is not paying the broker. It is we, the investors, who are paying the agents! It is OUR money and that is a DIRECT LOSS, an amount ripped off from OUR pocket!
Thus, the commissions we are paying are the same as fees. Fees are to be paid upfront and are much smaller. Imagine your broker asking for Rs.50,000 to fill up the forms! You would shoo him away! You end up paying the same amount for the same service because commissions are paid through the back door and they are huge!
Conclusion:
It should now be clear that Direct Mutual Funds are a much smarter way to invest, as the saved commission comes “back into your pocket” and earns more! Fees are what we need to pay for the services being sought.
Happy Investing!