Recommendations...We always want quick money
A small, secret tip from the broker who has just found a gem and he wants you to invest today and that too immediately. This is as if the secret is being let out in the market and he wants you to capture the opprtunity now. We are always in a rush when it comes to investing in stock market. This is something which Warren Buffet too mentions time and again whenever he is asked for the reason behind his success. When I look at my mother when she goes and buys groceries in the market, I am surprised by her bargaining power. She fights tooth and nail to get the best price and not get cheated. What more, the shop-keeper knows that my mother keeps a close track on the price movements of her products. Only thing is that she does not stock too much to taken advantage of price movements:)
When it comes to decision making in the stock market, this talent is missing. She totally depends on the broker/father. She does not even bother to see if the company exists or not. It puzzles me too. I am no different, but probably I fare slightly better than my mother. It is nice to see her decision making process. In the first stage, she is not interested in investing in the stock market as she has no knowledge in it. A wonderful stage, where we see most of the housewives. It is better being this way than investing blindly. It takes a lot of convincing to make her first investment. A little bit of opportunity(or greed, depends on the timing), and some confidence showing the limited downside can lead to the next stage of her first investment. In this stage, she makes the investment after consulting a lot of people. You will have to give a lot of reasons, some she may understand and some she may not. She likes to hear the good things, and when the person who is advicing throws a lot of jargons, economic fundamentals (and most importantly uses words like "look at people spending money, your recent purchases etc) she becomes confident to make the investment. In this stage, she is extremely active and looks at her decision making very closely and will keep calling the broker to get the comfort of her investment. The broker is not that concerned as his work is completed.
The next stage is where we all make the mistake. If the first investment was a successful one, which the broker is ready to point out, we start thinking of the next move. We are ready to make the next investment, which the broker has been secretly telling you. This time the stake gets bigger as you have the profits of the previous investment to fall back on. It is interesting to note that, most 'un-educated investors' assume that they can beat the market, by just getting out of the market before the others do. Rarely has one seen this happen. If this investment and few subsequent ones turns out to be good, one sees the control shifted from my mother to the broker completely and this is where the RECOMMENDATIONS starts kicking in. The recommendations which was just a guiding tool, becomes the most important decision making criteria to buy or sell and the broker, the WARREN BUFFET. The biggest feature of this recommendation is that it highlights the BUY more than the SELL. This again can be attributed to our decision making process. Once a decision is done, we do not want to be proved wrong or we believe there is unlimited growth to that stock. We just want to look at newer opportunuties to capture before anyone can. It suddenly becomes a RAT RACE. We are so involved that the previous macro economic factors of the country and the industry, profitablity, ROI, ROE, P/E's, promoter holding all is thrown out of the window. All that is important now is that call from the broker and hopefully CNBC, NDTV Profit, Dalal Street covering an attractive article of your stock. The funny aspect of this is the emotional aspect. Every new high of your investment makes us even greedier and every fall is just an abberation as the lesser mortals have yet to understand your reasoning. Your broker's reassurances will make things comfortable. How helpless we all become...
My mother who was leading a simple life suddenly is in the midst of a big confusion. Having invested her savings, she sees a life with too much activity, which she never wanted in the first place and that frequent recommendations made her life so miserable that she will never lead the life she always wanted. She probably will only know when the market starts to fall....
Note: I used my mother only to make things simpler. My mother has never invested in the market and she leads a simple life that I sometimes desire. She is totally against this market, as she believes it is speculative. She is right at times....
January 26, 2006
January 04, 2006
Expense Ratio... Who is looking when investing
When advising people on Mutual Funds, I always saw people looking at few parameters for investing. The first was always 'Returns'. To me this is extremely important, however I found this an extremely narrow minded approach to investing. When advicing we had to specify reason for investing in a scheme. So, in my first few months, one parameter I explained was the 'Expense Ratio'. This is the ratio a fund is being charged for the services offered by the fund house to manage the fund and this does not refer to the normal 'entry or exit load' which most investors are aware of. My customers were quick to shoot this down and look at the return and which area was it investing. If they were comfortable with the idea, the investment was completed and I return happy. Over a period, I too stopped explaining and preferred to explain only if the demand needed. The sad part was after a two years, I stopped looking at it. Only after I shifted my jobs, did I start looking at it closely and I was surprised to see what was happening.
To understand this ratio you need to understand where is the money being made by a fund house. Though mutual fund is formed as a trust, the underlying objective for any mutual fund company is 'Profit'. Fund houses make money on the expense that is charged to their schemes. So, in effect the more the company has assets, the more it makes money. In India, fund houses are regulated with the amount of expenses that it can charge. It differs based on two factors:
As it is easier for higher amounts of money to be deployed with no huge additioanl costs, fund houses are given ceilings for the expense that it can charge based on the assets that it has in the scheme. The charges are
However, this situation is completely reversed in equity schemes. Fund houses can differentiate themselves with better stock picks. So here we see most fund houses charging the maximum possible expense on the fund. This is where I find it unfair to the investor. The investor pays a load for entering the fund. Over this amount, he is charged with another 2.5% charge. This makes the investor to lose 4.75% on every investment that he makes. Also, this is under the assumption that the investor is for a year. Also, the current practise to churn the portfolio for better returns by moving to different schemes further worsens the matter. Though the expense is not a one time charge, a customer who shifts his portfolio twice a year ends up losing 6.5% p.a. This is a phenomenal charge, considering the returns that he makes.
The investor is least bothered of this issue today. With equity markets flaring, he is making a lot of money. Agreed that this returns is better than most asset classes but is the customer making the most of his investment. The investor has taken a risk by entering this product and the fund houses charge a load as 'fees' to give to the broker who brokered this transaction. The broker ensures that the fund being sold is always a load fund. Sometimes, fund houses remove this load for higher amounts. On most occasions, this would never be revealed to the customer. After this the customer is not aware of the expense charged on the fund. He assumes that the poor returns is always because of the poor stock picks. For this, I shall not blame the broker. I have tried to teach this to my customers and they are rarely interested in it. Hence, we see this practise by fund houses to charge as much as possible.
In the U.S. fund houses such as Vanguard, thrive on reducing the costs for a product and pass the benefits to the customers. The bonus for the employees are based on the costs that it has saved. We hardly find such a practise in India. Even if it followed like in cash funds, it is more with a reason to accumualate more assets than anything else.
I believe that this situation can be changed. Though it would take a long time. Firstly, fund houses have to change their way of operations. Mutual funds have gathered a good momentum this time in gathering assets in the current market. However, this is comparitively low when we look at its participation in the equity market. To improve this funds have to make the fund attractive, a reduction of expense is necessary as this automatically improves the customers returns. Also, the load factor. The fund have to start lowering their load as this prevents most customers to enter a fund. NFOs with 'no load' have been successful in the past. Though the fund houses had to burn their money to pay the broker, it showed the success of such ventures.
It is difficult to implement considering the nature of the distribution. If one was to look at the long term prospects of this industry, I believe this practise has to be established.
Secondly, Fund houses regularly interacts with its customers. The mailers it sends on its products can show the expense it charges. Sadly, today except Franklin Templeton, I do not see this practise elsewhere. Repititive information on expense is bound to create some interest. Agents may not like the direction this might lead, however I believe this will be good for the industry in the long run.
However small this issue maybe for the industry, I am concerned. As an optimist, I strongly believe this product to have the potential of being the most important channel for investing our savings and I do not want to see a bad landing as it has happened a few year back.
When advising people on Mutual Funds, I always saw people looking at few parameters for investing. The first was always 'Returns'. To me this is extremely important, however I found this an extremely narrow minded approach to investing. When advicing we had to specify reason for investing in a scheme. So, in my first few months, one parameter I explained was the 'Expense Ratio'. This is the ratio a fund is being charged for the services offered by the fund house to manage the fund and this does not refer to the normal 'entry or exit load' which most investors are aware of. My customers were quick to shoot this down and look at the return and which area was it investing. If they were comfortable with the idea, the investment was completed and I return happy. Over a period, I too stopped explaining and preferred to explain only if the demand needed. The sad part was after a two years, I stopped looking at it. Only after I shifted my jobs, did I start looking at it closely and I was surprised to see what was happening.
To understand this ratio you need to understand where is the money being made by a fund house. Though mutual fund is formed as a trust, the underlying objective for any mutual fund company is 'Profit'. Fund houses make money on the expense that is charged to their schemes. So, in effect the more the company has assets, the more it makes money. In India, fund houses are regulated with the amount of expenses that it can charge. It differs based on two factors:
- Type of Product being offered
- Size of the Scheme
As it is easier for higher amounts of money to be deployed with no huge additioanl costs, fund houses are given ceilings for the expense that it can charge based on the assets that it has in the scheme. The charges are
- first 100 crores-2.5%
- the next 300 crores - 2.25%
- the next 300 crores - 2%
- the rest - 1.75%
However, this situation is completely reversed in equity schemes. Fund houses can differentiate themselves with better stock picks. So here we see most fund houses charging the maximum possible expense on the fund. This is where I find it unfair to the investor. The investor pays a load for entering the fund. Over this amount, he is charged with another 2.5% charge. This makes the investor to lose 4.75% on every investment that he makes. Also, this is under the assumption that the investor is for a year. Also, the current practise to churn the portfolio for better returns by moving to different schemes further worsens the matter. Though the expense is not a one time charge, a customer who shifts his portfolio twice a year ends up losing 6.5% p.a. This is a phenomenal charge, considering the returns that he makes.
The investor is least bothered of this issue today. With equity markets flaring, he is making a lot of money. Agreed that this returns is better than most asset classes but is the customer making the most of his investment. The investor has taken a risk by entering this product and the fund houses charge a load as 'fees' to give to the broker who brokered this transaction. The broker ensures that the fund being sold is always a load fund. Sometimes, fund houses remove this load for higher amounts. On most occasions, this would never be revealed to the customer. After this the customer is not aware of the expense charged on the fund. He assumes that the poor returns is always because of the poor stock picks. For this, I shall not blame the broker. I have tried to teach this to my customers and they are rarely interested in it. Hence, we see this practise by fund houses to charge as much as possible.
In the U.S. fund houses such as Vanguard, thrive on reducing the costs for a product and pass the benefits to the customers. The bonus for the employees are based on the costs that it has saved. We hardly find such a practise in India. Even if it followed like in cash funds, it is more with a reason to accumualate more assets than anything else.
I believe that this situation can be changed. Though it would take a long time. Firstly, fund houses have to change their way of operations. Mutual funds have gathered a good momentum this time in gathering assets in the current market. However, this is comparitively low when we look at its participation in the equity market. To improve this funds have to make the fund attractive, a reduction of expense is necessary as this automatically improves the customers returns. Also, the load factor. The fund have to start lowering their load as this prevents most customers to enter a fund. NFOs with 'no load' have been successful in the past. Though the fund houses had to burn their money to pay the broker, it showed the success of such ventures.
It is difficult to implement considering the nature of the distribution. If one was to look at the long term prospects of this industry, I believe this practise has to be established.
Secondly, Fund houses regularly interacts with its customers. The mailers it sends on its products can show the expense it charges. Sadly, today except Franklin Templeton, I do not see this practise elsewhere. Repititive information on expense is bound to create some interest. Agents may not like the direction this might lead, however I believe this will be good for the industry in the long run.
However small this issue maybe for the industry, I am concerned. As an optimist, I strongly believe this product to have the potential of being the most important channel for investing our savings and I do not want to see a bad landing as it has happened a few year back.
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