Say no to NFOs, buy direct plans and seek suggestions from Sebi RIAs

The Securities and Exchange Board of India (Sebi) has implemented a new rule to curb unnecessary portfolio churn by distributors, usually done during the launch of new fund offers (NFOs) to pocket higher commissions.

 

Now, distributors switching investors from one fund to another will receive the lower commission of the two schemes.

 

“Sebi’s new rule is a positive step towards investor protection. It will reduce mis-selling by aligning distributor incentives with investor interests and discourage unnecessary portfolio churn. It will promote long-term stability in investment portfolios,” says Vivek Sharma, investment head, Estee Advisors.

 

Mis-aligned interests

 

A key driver of mis-selling is the conflict of interest between distributors and their clients.

 

Asset management companies (AMCs) have been launching sector, thematic, and strategy-based NFOs. “The industry’s practice of rewarding distributors with higher commissions on NFOs often skews their recommendations towards these schemes,” says Nehal Mota, co-founder and chief executive officer (CEO), Finnovate.

 

She adds that new AMCs entering the market also offer high commissions to promote their offerings. Both NFOs and schemes of new AMCs lack adequate track records. Investing in them goes against investors’ interests.

 

Smaller active funds, with assets under management (AUM) of less than Rs 500 crore, can charge up to 2.25 per cent annually, compared to 1.25 per cent for the largest active equity funds.

 

“If a distributor can switch a client from the largest to the smallest funds, the fees can increase by around 100 basis points (bps) per annum, which can be shared by the fund house and the distributor,” says Avinash Luthria, Sebi-registered investment adviser (RIAs) and founder, Fiduciaries.

 

Another factor enabling mis-selling is the lack of financial literacy among investors, who often do not scrutinise the products they buy. “Mis-selling always occurs where there is mis-buying,” says M. Pattabiraman, associate professor, IIT Madras, and founder, Freefincal.

 

Adding to the issue is the blurred line between investment advice and incidental advice provided by intermediaries.

 

“Sebi says only RIAs should provide investment advice and intermediaries should only provide incidental advice. In most cases, there is not even a thin boundary between investment and incidental advice. Many distributors provide investment advice,” says Pattabiraman.

 

Grave consequences

 

The negative consequences of mis-selling are significant. “It results in products being recommended that do not match an investor’s goals or risk appetite. Distributors often conceal costs like expense ratios and exit loads, or downplay the dangers in high-risk funds,” says Sharma.

 

How to avoid mis-selling

 

One effective way for investors to avoid mis-selling is to take the DIY (do-it-yourself) route and opt for direct mutual fund plans using a platform such as MFCentral.com.

 

“If they need advice, they should get it from professional advisers who do not have any conflict of interest,” says Pattabiraman. He recommends Sebi RIAs, who charge a flat fee independent of client net worth.

 

Distributors rarely recommend passive index funds, such as the Nifty 50, because their commissions — around 15 bps or slightly higher — are much lower than from active equity funds.

 

“Reduce the total expense ratio you pay by investing in passive index funds,” says Luthria.

 

Investors must take control of their asset allocation and not leave it to distributors. “Distributors have a vested interest in hard-selling equity funds,” says Luthria. This can result in portfolios whose riskiness exceeds the investor’s risk tolerance level.

 

Above all, improving financial literacy is critical. “Only then can you make informed decisions and avoid mis-selling,” says Mota.

 

Checks to run before purchasing a fund

 

*  Enquire about the scheme’s total expense ratio (TER); if it’s high, assess whether the recommendation is driven by distributor margins; also, review weighted TER of portfolio

  *  Avoid investing in NFOs; prefer established funds with a solid track record and sizeable AUM, which are generally more cost-effective

  *  Assess the fund’s performance history, and track record of AMC and fund manager

  *  Evaluate fund’s rolling returns to gauge consistency

  *  Go for funds with high risk-adjusted returns, measured by Sharpe and Sortino ratio

  *  Compare fund’s performance against relevant benchmark

Source: Finnovate