Mutual Fund or Distributor’s fund?

Economic Times has a story on Indian Mutual Funds. The article lists 10 Fund houses whose AUMs have declined severely in November 2008 compared to October 2008 . In order to boost sales:

In their bid to bolster their sagging assets under management (AUMs), mutual fund houses are pampering distribution agents with unique incentives to boost sales. Fund houses are handing out upfront commission and other monetary remuneration to increase fund sales. Instead of annual commission, which was the case until some time ago, fund houses are now offering an upfront commission of 1% for selling gilt and income funds.

Among a host of measures adopted, fund marketers are promising higher commission on schemes sold. In addition to the 2.25% as entry load and 0.5% trail commission, distributors are being offered 0.5% extra commission for everytax saver fund sold.

I am not sure how to react to this story.  Mutual Funds are for retail/small investors but has been in news for all the wrong reasons. First, they seem to be passing on a chunk of returns to distributors. Second, seem to prefer institutional investors instead of retail investors. Third, which has become a latest trend is the compensation packages at these funds turning new highs.

I had pointed to a story of a Mutual Fund that tried to create space without using distributors but failed miserably. The MF in story was shocked to see the role distributors play in the scheme of things. Then I had also pointed to a recent story where Mutual Funds offered assured returns to institutional investors. There was another story where Mutual Fund despite the fund closing down all that was happening was securing lucrative exit packages. There was another story of Fund managers’ salaries touching  new highs which made me ask this question – Are India’s financial markets getting efficient?

And now this story of passing on incentives to distributors. And what would distributors do? Simply push those funds which have the highest set of incentives for them. And who would suffer? The retail investor for sure. I am not against distributors but there have to be some benefits for whom the product is intended.

Distributors help in 2 ways: First, they help MF reach across to retail investors in their respective areas and create awareness. Second, a new MF might take up time to set its own distribution chain so they can use them.  This is actually similar to other products as well with one crucial difference. I always use this Obstfeld explanation:

The basic differences relate to the intertemporal nature of financial trades and to the potential for asymmetric information to eliminate trade gains. Asset trade inherently involves commitment – the commitment to pay on a later date. Payment in reality is therefore always contingent, and the circumstances of contingency can depend on information known to only one party to the deal. Thus, financial transactions inherently must allow for the asymmetric-information distortions that we call moral hazard and adverse selection. These distortions reduce the gains from asset trade that would otherwise be available – even with an efficient and impartial judicial enforcement system.

Again, the difference compared to goods markets is a matter of degree. A consumer durable yields returns over time, it may be known to the seller to be a “lemon,” yet an unconditional service contract may leave the owner with insufficient incentives to operate the durable good appropriately. But there is no doubt that commitment and informational problems are by far most severe, and have the widest systemic ramifications, in the financial market setting.

That is the main argument. Benefits of a financial product accrue much later compared to a real product. Hence, the Mutual Funds/ distributors have a much important role to play in selling Mutual Funds. Moreover, we hardly see MFs giving same benefits to retail investors as other companies do. There are ample cases of companies passing on discounts/benefits to buyers via distributors but hardly anything for retail investors.  MFs pass most benefits to distributors. And all these benefits are passed on from retail investors monies (this is true for institutional investors as well, but they can afford it).

I had this huge debate with a dear cousin over this entire MF industry and its practices. We both agreed things are not right in MF industry but had different ideas for a way out.

I said Mutual Fund Management should be more responsible towards its actions as it deals with small investors. Profits are important but it shouldn’t be at the cost of the investor. He said, retail investors should be responsible as well and not buy funds blindly (I agree to this but then why have distributors/advisors at all? financial education and literacy are pretty difficult ideas and would take a lot of time). He said profits are key to any business and same applies to MFs as well. So, they will never care as long as they make profits. The only way they can learn is damage of credibility which always happens in times of crisis (unfortunately are forgotten pretty soon).

What do you think? Do let me know.

6 Responses to “Mutual Fund or Distributor’s fund?”

  1. Ankit Sharda Says:

    How about disclosing commission paid to the middlemen(read distributors) to the ultimate beneficiary(read consumer)? I don’t think it is done very conspicuously. And this way, buyers of mutual fund unit would be able to sense potential conflict of interest.

  2. Mutual Fund or Distributor’s fund? « Mostly Economics | Says:

    […] See the original post […]

  3. Mutual Fund or Distributor’s fund? « Mostly Economics | Says:

    […] Read the rest […]

  4. The Wall Street Culture that led to crash « Mostly Economics Says:

    […] error of index funds I am told is quite high which also is not understood. It is much better to be distributor of the funds (see this as well) or be an institutional […]

  5. Libertarian Paternalism happening in India and US « Mostly Economics Says:

    […] again a continued form of LP from SEBI. I have bragged in numerous posts how mutual funds in India(see this one, see US case) are actually a distributor’s fund with most benefits going to a distributor […]

  6. Mutual Fund Says:

    Really thanks for this information. Hoping to get more updates form you. 🙂

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