Switching funds: The latest con

Stock markets are falling sharply. Your mutual fund portfolio is probably not doing as well as you expected. You want to make some adjustments to your portfolio, but you don’t know which mutual fund should be retained and which one must be redeemed. You approach the one person who you believe has the answers – your mutual fund agent/advisor.
Your mutual fund agent has played a critical role in helping you invest in the schemes that he believes are best placed to help you achieve your investment goals. So every time you feel the need to revamp your portfolio (in falling markets, for instance), it is natural for you to approach him for his views. The honest investment advisor will usually give you a frank assessment of where he believes he went wrong (if at all) and what steps must be taken to set aright the wrong investment decisions. If it’s in your best interests, he will advise you to redeem some of your funds and shift to a better fund regardless of how much commission he is making.
If you have an honest investment advisor, then you can consider yourself fortunate. However, if you are associated with the kind of investment advisor who is more likely to worry about his own commissions than the performance of your portfolio, then you have a problem. This advisor is more likely to recommend schemes that earn him a higher commission or at least a minimum commission that makes it worth his while to service you.

Increasingly, we are hearing of cases where clients are advised to invest/redeem based on absurd premises. Recently we heard from a website visitor who was advised by his agent to redeem an equity fund that was not performing up to the mark by switching to another equity fund (which happened to be a mediocre performer as well, but marginally better than the first fund) from the same fund house. His rationale for this strange recommendation was that at least the investor would save on the entry load on the new scheme since switches within the same fund house do not attract an entry load (however, the investor has to pay 0.25% Securities Transaction Tax on redemption and bear the exit load). According to the advisor he was saving his client the 2.25% entry load that he would have paid if he had shifted to an equity fund from another fund house.

Clearly this recommendation is flawed on many counts. First and foremost, the investor needs to evaluate whether he really needs to switch. In a falling market, equity funds will fall. So if the investor’s fund is falling it is not a cause for concern per se. However, if he has been told that it is a conservative fund and but is still falling harder than the markets, then there could be a problem. However, if it’s falling lower than the markets then there is no real cause for worry, in fact it only establishes that it is a true blue conservatively managed equity fund.
The financial advisor is only exploiting a common investor weakness for something ‘new’. Under pressure to recommend something different, he recommends another fund from the same fund house.
But why does he recommend another fund from the same fund house? There could be several reasons for that, but two reasons are particularly noteworthy. Usually, mutual fund agents get varying commissions from various fund houses. If the agent gets a higher commission from a particular fund house then it’s in his best interests (financially) to ensure that his investors remain with that fund house. Hence the advice to switch to another scheme from the same fund house.
Another reason why investment advisors recommend that their clients remain with the same fund house is so that they can save on the entry load. While this advice appears to be in the investor’s favour, there is more to it than meets the eye. Since the time SEBI (Securities Exchange Board of India) has made it possible for investors to invest directly with fund houses (and bypass the distributor), the investor is increasingly getting intolerable about entry loads. So long as he is made to switch within the same fund house he does not have to pay an entry load. This makes him agreeable towards such a move. But if his advisor were to make him invest in another fund house, there’s a fair chance that the investor would rather invest directly and save on the entry load than route the transaction through the advisor.

Conclusion:

The investor must take an objective view on his investment portfolio. He must first evaluate whether his fund is as bad as he believes it is. For this, he must compare it with the broad market. If he is invested in a thematic fund because he has the risk appetite for it, then in a market fall his fund is likely to have fallen harder than the broad market. So there is no real cause for concern because this is how thematic funds are supposed to perform (they are also meant to rise faster than the broad market in a rally). In such a scenario, there is no reason to switch to another scheme.
However, if the fund’s performance is not upto the mark and the underperformance is consistent, then there is a case for considering a switch to another fund in its peer group that has performed as per expectations. While selecting this fund no consideration needs to be given for whether the fund is from the same fund house or a different one. The only consideration should be that it is right for the investor and makes an apt fit in his portfolio.