Mis-selling in Mutual Funds

February 06 , 2013

In any financial product, at a given point in time, the sum of value to a customer, agent, government and the company is always zero. Note that this zero-sum game is valid only at a point in time. Over time, the corpus itself can grow and provide more for everyone.

"But," you might say, "Isn't that the same in everything I buy, say Dal at the Kirana store?" Well, yes. But with two important differences:

  1. Dal is a consumption product, qualitatively different from the money you use to buy it. On the other hand, financial assets themselves are not for consumption. You hope to covert it back to money sometime later. So anything that leaks out during the conversion in either side, is irreversibly lost. It directly reduces the money you get back later.
  2. More importantly, when you go to a Kirana store, you make most of the purchase decisions. If the store were out of Tur Dal, would you buy Channa Dal instead? More likely, you would go to another store and buy the Tur Dal you want. In finance it's a bit different - you ask the broker himself which fund to buy! He naturally recommends what's good for him (i.e. gives him maximum commission), and not what is good for you. What helps him is the fact that you realize the product is rotten only years later, by which time he is long gone.

Would someone like a trusted Bank recommend bad products?

Possibly yes, though not necessarily. All we can say is that you are asking for trouble. The guy who sells you the funds typically has no clue which funds are good. So even if he wanted to do you good, he typically cannot. We have seen very few Banks have a good research desk. And even fewer make sure their sales people sell what their research recommends!

For sure, the Bank wouldnt disappear with your money. But if an investment turned out to be bad, it would sure shrug and say that you made the decision yourself.

What can help?

Only two things we can think of:

  • Think and learn before you buy - We are amazed at how few people know what they are getting into. If you buy due to the persistence of the sales person without understanding the product yourself, you are sure to get conned in this industry.
  • Take advice from someone other than the broker. The distinction between advice and execution is especially important since brokers get paid a commission depending on the product you buy. They will naturally recommend high commission products, which, by the zero-sum theory given above, means you end up with less.

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