Fees | Portfolio Yoga

Portfolio Management Services – understanding it better

At a time when Mutual Funds are seeing withdrawals, assets for Portfolio Management Service (PMS henceforth) are blooming. This even though Mutual Funds are better off when it comes to how one gets taxed as well as the fees. Mutual funds, even the active funds charge these days much lower than what the investor ends up paying at most portfolio management companies.

For the outsider – a Portfolio Management Service is very opaque. Maybe this is what gives them the edge – the exclusivity that investors demand after having achieved a certain level of financial well being. With the minimum investment of 50 Lakhs, its a signature investment of having arrived.

When SEBI introduced the concept of PMS, the spirit behind it was that high networth individuals would want to have professionally managed but personalized investment services. Before the arrival of rules, we did have brokers who acted as fund managers but without much oversight or transparency.

Today there is very little personalization in reality with most fund managers offering the same model portfolio for all clients regardless of his or her requirements or risk tolerance. The only difference lies in their ability to have a higher concentration versus Mutual Funds.

The biggest bane for the HNI investor is that mutual fund managers are never available to speak to unless one is big enough to move the needle for the firm. On the other hand, many Portfolio Managers will be happy to meet investors and if the investor is big enough, willing to drive down to his place if required. Whoever said Money can’t buy everything evidently hasn’t worked in the financial services industry.

Analyzing a mutual fund is very easy. It’s easy to get access to the funds historical day to day returns, their monthly portfolio’s, the fund managers letters and ability to compare the fund with others in the same category using freely available screeners.

Analyzing a Portfolio Management Service on the other hand is so much harder. Almost all PMS companies are wary of any disclosure of the portfolio – not even the top holdings get disclosed. Returns on the website of the firms are generally (with exceptions) dated.

Over a three year period, an investor could end up (markets being good and performance inline) paying the fund manager a few lakhs in fees. It hence makes sense to invest some money and time to decide on whom to bet with and there is nothing like a good old one to one personal dialogue with the fund manager to convince you of the merits of your decision.

Websites like PMS Bazaar offer a way to compare multiple PMS providers but only if they have tied up with the company. As per a Business Line article, they have tied up with just around 100 firms which means that 250+ firms are outside their database.

One can get the monthly returns from SEBI website where the same gets posted by the respective fund houses but until recently it was a single number regardless of the number of styles / strategies they were running. Also, did I mention the pain of trying to download data month on month for each fund house?

Returns of the past also need to be looked at with context of what is happening in the markets. In 2017, investors rushed to invest with small cap PMS funds only to get severely burnt as the markets rolled over.

Filtering down the list of suitable candidates with whom one wishes to invest is hard but essential for the next steps are time consuming. The key is to try and reduce the list of probable candidates to say 10 fund houses and then dig further.

So, how does one go about eliminating the funds one does not wish to invest into. For most investors, this process is by selecting only funds that are well known or have a large asset base or managed by a fund manager who they trust.

This eliminates the majority but also eliminates good fund managers for the single reason that they haven’t grown big for their brand to be noticed. In the Mutual Fund space this doesn’t happen because of availability of data.

Unlike Mutual Funds, we don’t have comprehensive data on how much of inflow is due to push sales and how much due to pull. While PMS is supposed to be for the discerning investor, there are still a lot of push based sales where the client takes the advice of the seller in deciding which fund he shall invest into.

In its early days, PMS was sold only by Wealth Management Firms for their clients. Today selling PMS is something that is undertaken by a whole gamut of individuals. Then again, while one shall get around 0.75% for selling a Mutual Fund, the fee a distributor gets for selling a PMS is much more liberal (some PMS share even the performance fee with the distributor who brought the client).

With minimum investing being 50 Lakhs (some PMS have a higher minimum), this for most would be a substantial investment. An investor faces two risks with any investment – the risk of an actual capital loss and the risk of an opportunity cost.

The risk of actual realized losses is easily spotted, tougher is to spot the opportunity cost. Benchmarking is one way to spot the opportunity cost. Beware though of using the wrong benchmarks for they can make an old person look young.

The best benchmark is not the Index but Mutual Funds. This is because other than for Large Caps, the other Indices suffer from a bias where their best stocks get removed frequently and thus limits their upside. The only stocks that are removed from Nifty 50 or Nifty 100 on the other hand are those that aren’t performing.

With very little if any disclosure of portfolio holdings, the next best step when it comes to analyzing a fund manager are his public writings – do note that not every fund manager writes a monthly or even a quarterly letter to clients and one that is provided to the public.

To understand a company, the key is to go through a few years of Annual Reports. Similarly, one would need to go through a few years of the letters. The idea is to get an understanding of the philosophy of the fund manager

The reason to read is that the investor would want to have a long association with the fund manager and that can only happen if the philosophy he talks about appeals to him. While returns are important, given the lumpiness of returns, the ability to stick with the fund manager during the bad times helps take advantage when the tide turns in favor of the strategy of the fund manager.

To better understand how lumpy returns can be, here is an example. A large PMS fund at the end of May 2020 had a 4 year CAGR of -1.60%. The CAGR at the end of May 2021 comes to 15%. 4 frustrating years were offset by one good year.

The only way to stay with the fund manager after seeing multiple years of gains being wiped out is only by having conviction both in the fund manager and the strategy he is implementing.

Not all PMS’s can be compared for their universe could be different. While the majority of PMS go for the Multicap universe, some PMS restrict themselves to Large Cap or Small Cap. This is an important distinction.

Size Factor is a phenomenon where it is observed that mid and small cap firms in the long haul have a tendency to outperform large cap. This outperformance comes from the portfolio’s being more risky in nature and the rewards if captured are a prize for taking those risks.

While Mutual Funds are forced by law to be more diversified – Concentrated Portfolios is the biggest differentiation for PMS. Concentration in itself doesn’t mean a higher risk though the volatility would be higher.

Finally, the elephant in the room is fees. Today, an investor can get an Index fund that costs as low as 0.20% of investment. Active funds but Directly invested by the investor would end up being charged 1% approximately.

PMS follow 3 different styles of charging to clients.

Fixed Fee Only: The fund manager here charges a fixed fee on the total assets managed and the calculation is similar to how it is calculated and charged at Mutual Funds. This ranges from anywhere between 1% to 2.5% of your assets.

The biggest advantage of a flat fee – it’s clean and easy know what one shall pay

Performance Fee Only: Rather than charging a fixed fee, some PMS firms offer to charge the investor a fee if they deliver above a certain hurdle rate. From the limited data I have, I have seen this hurdle rate being 6%. Given that until recently you could get 6% from a Risk Free Investment, this hurdle was in effect saying that if I don’t outperform the risk free, I don’t get paid. The way it’s calculated is that if a fund generates say 12% returns for the year, for an investment of 1 Crore and a performance fee of say 20% above 6%, you will pay 1.2 Lakhs (which is equivalent to a fixed fee of 1.2%).

The reasoning behind charging only a performance fee is to suggest that the fund manager will get paid only if he delivers for the client. While on the surface it seems logical, do note that in the long term, an Index fund has on an average delivered 12% returns.

Lower the hurdle rate, higher the fee the investor will end up paying. In good years like FY 2020 – 21 when Nifty went up 66%, the fee would come to 12 Lakhs( or 7.2% of the total current value of the fund – post 66% appreciation on an investment of 1 Crore). This of course assumes you invested on April 1, 2020.

While the investor will not pay any performance pay till the high water mark, if he were to exit during a drawdown, the investor would have ended up paying more than what he may have paid using the simple fixed fee route.

Fixed Fee plus Performance Fee: Finally, there are funds that charge you both a fixed fee and a performance fee. The hurdle rates here are a bit higher but not that high that makes it tough to generate any performance fee in the long run.

While this is how most Hedge Funds charge their clients, this is also in a way trying to maximize revenue for the fund manager at the expense of the client. In a good year like the one just gone by, the fee would easily be multi year fees for any active mutual fund.

Performance fee in my opinion should be calculated on the Alpha generated over and above the opportunity cost. The opportunity cost would be what one would have chosen as an alternative investment. But there is no such model available as far as my knowledge.

In addition to the fees, PMS also passes on all incidental expenses that are directly relatable to your account such as Broking, Demat, custody etc. This can easily come to 0.4% and something to keep note of.

For the investor, the biggest difference is how one gets taxed with respect to gains. If one is investing for the really long term, say Retirement Goal, with a Mutual Fund one pays Zero taxes as long as one remains invested. In a PMS, it’s normal for the investor in a PMS to regularly pay capital gains taxes on profits books by the fund manager.

Depending on the holding period of the fund manager, this can dampen the returns substantially if there is a high degree of churn. It goes unnoticed for most until the time to pay the tax arises. But in a good year, one is already happy and he or she is unlikely to complain with respect to paying taxes for the investment has grown substantially too.

The biggest advantage of PMS is the transparency (once you are a client) with respect to transactions. You get to know each and every transaction which while may not be really useful in the larger framework , it can provide you inputs on the thought process of the fund manager.

Once upon a time, Stock Brokerage was a personalized business which allowed the broker to charge you 2.5% and then some more and yet have the client not complain. Technology rudely awakened that Brokerage is finally no different from any other commodity business and the friction costs have reduced to Zero.

With the advent of more low cost ETFs that cover a gamut of strategies and tech enabled platforms, my view is that managing one’s one money based on one’s own convictions will become easier. While managing money may never become a commodity business, over time fees should go down from what is seen as acceptable today.

A new concept that is picking up in the US is “Custom Indexing”.An interesting concept where the advisor or his client has the ability to modify the portfolio to suit their custom requirements. Patrick O’Shaughnessy has a podcast which is worth a listen (Link).

FAQ on PMS by SEBI

Advise is Cheap, Advisory is Not

Twitter for the financial community has been a fine place for exchange of ideas and thoughts. While the #fintwit community is not very large, it’s decent enough to generate interesting conversations around the world of finance.

For all the talk of we not being part of a herd, if you were to just scroll around with an open mind, you would see that talk is cheap and action is missing. The bigger the number of followers, the rarer he or she will openly challenge a fellow fintwit. let sleeping dogs lie as the Iodim goes.

While we laugh at others who we feel are stupid enough not to recognize the reality, Once in a while I feel if we are in a echo chamber ourselves. We have our strong beliefs and no matter the evidence we will continue to stick with our beliefs while either ignoring facts that challenge our assumptions or worse show us to be wrong.

One of the fantastic writers I have come across in the Indian fintwit community is @PassiveFool. I love reading his long newsletter filled with thoughts most of which I agree with or make sense. But once in a way, he takes the logic way too far and one that makes no sense at least from where I come from. His latest tweet thread was one example and I retweeted disagreeing with him.

Sorry but disagree. The comparison for returns should not be Index Funds but alternative investments – FD / ULIP / Real Estate. https://t.co/q6zp9Ld7te
— Prashanth (@Prashanth_Krish) November 30, 2020

One of the negatives of twitter is the limitation of words, so let me break down why I think he is wrong in the long form here

The first tweet has two numbers – one the amount of money HDFC makes from Prashant Jain funds and second the under-performance in the same period vs the Large Cap Index. Both these numbers are correct I believe but yet provide the wrong context.

The 700 Crores HDFC makes is not because of various reasons including the fact that they have been able to build a very strong distributorship who are willing to side with the fund manager despite the bad days he is seeing currently.

But here is the thing – what if you looked at the same data in 2015 (5 years comparison vs Nifty Total Returns). To compare, I shall use HDFC Top 200 fund – the fund that is no more in existence today but the prima donna for HDFC for a really long time and one Prashant has been managing

While Nifty delivered (including reinvestment of Dividends) a absolute return of 70%, HDFC Top 200 outperformed it by delivering 92%. In other words, if the same question was asked at the beginning of 2015, there would not be a tweet saying that HDFC was earning despite underperformance. Lets move to the next tweet that gathered my attention

https://twitter.com/passivefool/status/1333300261717110786

Again, the data is correct. 80% or so of the Assets that are coming into the asset management firms are coming from distributors but are they getting scammed? Scam to me is a word that is better used when investments are suggested where there is low probability of getting the principal back, let alone interest.

I don’t know if mutual funds calculate the total returns they have generated across clients – kind of Lifetime Customer Value – but if they do, I am pretty sure it’s strongly positive. Investors have made more money compared to what they have invested.

Cost is a very relative term. Active funds are expensive compared to Passive Funds. But are they the only choices investors have when they wish to decide where to invest their excess savings?

Regular funds are expensive because there is a cost involved with having a research team and the support around it compared to copying the Index where the research is outsourced. A Portfolio Management Service company for example needs to have a AUM of at least 100 Crore to breakeven. The breakeven for Mutual Funds is way higher. Someone has to pay.

https://twitter.com/passivefool/status/1333300263612866560

I am in complete agreement here and have written it multiple times as well. But Cost is just one part of the equation – the other part being service. I have blogged about how I started out as a Fixed Deposit Canvasser when I first started testing the financial services business. I got sidetracked by the Secondary markets and did not go the Mutual Fund Distributor route.

But a MFD is not someone who just tweets about the good things you can achieve by investing. Most MFD’s are literally putting their neck on the line for the meager commissions they get for the work they put in. What work you may wonder does a MFD do – all he needs to do is select the best performing fund and have his client invest and voila, its done.

The reality though is quite different. Most clients expect the advisor to be available and not just on a telephone call but physically at least in the beginning when the relationship is still getting built and trust getting established.

Since Portfolio Yoga started its advisory services, I have talked to a lot of prospective clients. Some felt that the service was worth the price, some did not. But everyone had their share of questions which they wanted answers for. Investing is not like buying potatoes where the worst thing that can happen is that you bought rotten potatoes.

The trend towards passive in the United States has been gathering steam enormously in recent times. But is it even right to compare what advisors are able to do there versus advisors here. Let’s take a look.

The guys at Ritholtz have been great proponents of Passive in their various blog posts and books. They offer to their clients investment advisory services through Comprehensive Portfolio Management. With more than a Million followers, the CEO is a star on his own. So, who do they serve and how much do they charge?

Their minimum for getting started is $1,000,000. Not much different from what our Portfolio Management Firms though here it’s because of SEBI mandate and there it is not. In other words, if you are not having that much money to give them to manage, they aren’t really interested in you.

But if you think about it, this makes sense. It’s all nice to talk about the small investor, but who will bear the cost of helping him reach his goals and provide him the pep talk he requires when markets melt down like it did in March.

The fee they charge for the Financial Planning & Consulting (and one they are able to auto-debit) ranges from 1.25% to 0.35% based on the Investment Amount (higher the Investment, lower the scale). The asset weighted fee for Regular Mutual Funds in India is around 2%. This is higher than 1.25% but on the other hand, you can invest a small amount and still call up your ~~advisor~~ distributor whenever you feel overburdened by everything that is happening around the world and want to change your fund.

For long I was in the same camp of Passive – why are guys so stupid I have felt and many a time verablly blurted out. But the problem as I see is that I was seeing from where I stand – me being someone who is in the Industry for 20+ years and understands it much more than someone whose only financial investment before this was a Fixed Deposit (or a LIC scheme his Uncle sold him).

It takes enormous efforts to help him understand the nuances of finance and how over the long term, it can help build a reasonable nest for himself. The alternative as I wrote to Regular Funds is not Index Funds but Fixed Deposits or Real Estate or anything else where he either understands the product or is sold the product by someone who is angling for a fat commission. If anything, selling Mutual Funds is one of the toughest jobs and one that really doesn’t pay well either.

Index funds are great – but you reach that stage of Nirvana after having exhausted every other path. Most don’t get to reach that stage of enlightenment right at the start unless they are really fascinated by the world of finance and investing.

Save Early or Lose Substantially?

An often repeated mantra is that if you don’t start saving early, you end up losing tremendously. You cannot argue with a statement like that , especially when it’s backed by evidence of the difference in returns if you start at 20 or start at 30.

Keeping in mind my skepticism with much of what goes around as “gyan”, I made this kind of sarcastic tweet in reply to one such tweet. Now, just to be clear, I hold Dinesh in high regard for his understanding of Finance and while I did use his tweet as material to push my agenda, it has nothing to do with him perse.

https://twitter.com/Prashanth_Krish/status/1327548992037609472

Kids in the US are burdened by Education Loans they take. The burden is so heavy for some that they would need to keep paying off till retirement. So, why do they even bother? The reason is simple – higher the education, more the remuneration and lower the possibility of being unemployed

https://twitter.com/Prashanth_Krish/status/1327624954192412672

One would rather be employed and paying off debt than unemployed with no debt but no optimism about the future either. While I don’t think that education in itself is everything, it’s a foundation that can help a lot.

Let’s go back to the original tweet. What is seen is the difference in outcomes based on a straight line approach to savings. If you start saving at 20, you are way better off than someone who starts to save at 30 assuming both end at 60. This is not surprising and it’s not just about compounding effects. Person A is saving for 40 years versus Person B who is saving for 30 years. 10 years of savings and the compounding does matter as the chart below shows

There is a very big hidden assumption here. Not only is Person B starting at 30 which is 10 years later than Person A but he is investing the same starting capital. What if rather than invest 10K per month, he is able to invest more?

When he is 30, Person A is investing roughly 16,300 per month (10,000 per month with an increment of 5% per year). If Person B starts his year 30 by investing 31,800 per month (close to double what Person A is investing) which too increments by 5% per year, this is what the chart looks like

Basically, by starting with a higher number, Person B despite starting late is able to catch up to Person A.

But he is investing more, you complain. This is true. My assumption is of course that he has not whiled away his time between the age of 20 to 30 but gathered either diverse experience which helps him earn more or got himself a higher degree which provides a higher salary and hence even with a similar savings rate is able to save on an absolute terms a higher number.

But lets equalize it in a different way – let’s assume that both work for the same period of time – 30 Years. Person A hence retires at 50 while Person B retires at 60. When Person B starts to invest, we assume he will invest the same amount per month that Person A is investing at that point of time and increment 5% per year. Where will they be when they hit 60 years of age?

We are back at Point 1 though slightly better. Person B trails Person A by nearly 50% even though Person A has retired a good 10 years earlier.

But there is another assumption we are overlooking. We are assuming that both of them get similar returns. How much of a higher return should Person B get to catch up with Person A at the age of 60?

The answer to that is 15%. If Person B can get 15% per Annum vs 12% per Annum for Person A, at 60, both of them end with a similar capital.

Here is the interesting thing. Both Person A and Person B can expect 15% from Equities and still end up at the same outcome at the end. The difference though would come from Asset Allocation.

While Person A can have a 60 / 40 Asset Allocation in favor of Equities and reach the number as Person B who is forced to have 100% in Equities. In other words, though both have similar return expectations from Equity, the allocation they need to take will be different.

For Person B to have the same outcome as Person A with the same Asset Allocation, he will need to generate 20.3% from Equities – something that very few have been able to achieve in the long run.

On the other hand, Costs can play a large role in the final outcome. Assume both invest in Large Cap Equity but Person A invests through a Mutual Fund Distributor in a Active Large Cap Fund whereas Person Invests in a Large Cap Index Fund / ETF.

While both of them will hold a similar portfolio {minimum of 80% matching}, Person A is paying a 2% fee vs Person B who will end up paying 0.10%. That is a straight forward gain of 1.90% and actually reduces the requirement for Person B to outperform Person A by that much. To get 15% returns in Equity after fees, Person A has to have a fund that delivers 17% vs Index fund Returns of 15.10%. If you have looked at SPIVA data recently, you shall notice that most Large Cap have it hard beating the Index let alone by that margin on a long term.

When we were young, we were taught the concept and Importance of Savings by stories such as the Ant and the Grasshopper. I don’t think we should deny the importance of a disciplined saving from an early age. But is everything lost because you started late though the barriers are higher.

While I do like the message of saving early being good there is nothing to be scared about if you started out late. Finally, it’s not the amount you have at 60 that really matters as much as the quality of life you have lived. The very fact that you are reading this puts you into the 10% of the population and one that is most likely to succeed as well.

Want to Stress Test your Retirement – check out the simple calculator(s) here. Of course, the assumptions build in here are US related, but should give you a chart of how other paths than the one excel plots.

Learning the Wrong Lesson from Bogle.

Human Life Expectancy today is 79 years. Most of us live out the lives in a fashion that none other than family members can remember one after we pass away from this world. Those who achieve greatness in their lifetime are generally remembered for at least one more generation before the memory stats to fade away.

Peter Houston, invented the first roll film camera but it was George Eastman who was well known thanks to he being the licensee of the patent on roll film and starting Eastman Kodak Company. Anyone born in the last couple of decades will barely remember roll film based cameras while the coming generation will mostly know camera as something that is part of a phone.

Throughout history, very few innovators have also been able to make a name by building a business around it. Exceptions to the rule are people like Henry Ford who founded the Ford Motor Company in 1902. Thomas Alva Edison was another for who hasn’t heard about General Electric.

John C. Bogle who passed away recently will be someone who will be remembered for a very long period. But will he be remembered right is the question that haunts me today as I read through the Eulogizes.

Yes, he was not just the founder of Vanguard which today ranks among the top fund houses in the world. He is celebrated for founding and popularizing “Index Funds”. Today, his view that rather than attempt to beat the Index, it’s far better and wise to just mimic the index performance through Index funds and Exchange Traded Funds is fast becoming mainstream with even Warren Buffet, the guru of active investing advising investors to go “Passive”

But is that what Vanguard stands for today? While billions of dollars have flown into passive funds in the recent past, Vanguard as of June 30, 2018 was managing just over One Trillion Dollars invested in active funds. Yep, you heard that right – the apostle of Passive Investing runs over 80 active funds.

Recently, one of the better writers of our time, Morgan Housel came to India to deliver a lecture at the India Investment Conference. He is a fantastic writer with focus being on behaviour finance. In one of his earlier interviews with Vishal Khandelwal, he mentioned that his investment consisted of only Vanguard Total Stock Market Index. He talked about the same in an interview to ET Now a few weeks back as well.

Morgan works at Collaborative Fund. Collaborative Fund is a Micro Venture capital that has through 4 funds raised $250 million from investors for investing into start-up’s. If active investing were to be graded based on the risk profile of the investment, active investing would be right up there along with Private Equity and other new age investing beliefs.

“Don’t look for the needle in the haystack. Just buy the haystack!” wrote John C. Bogle in his book, The Little Book of Common Sense Investing.

David Swensen, the chief investment officer at Yale University writes,

“Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.”

In his book, Unconventional Success, he presents the following table;

In other words, most investors in PE funds, Hedge Funds and Venture Capital funds will generate sub-par returns. Yet, Trillions of Dollars chase the fantasy of being able to invest in the fund that may fund the next Facebook or next Alibaba.

I am a great fan of Morgan Housel’s writing yet wonder if he truly believes in what he says & I quote “I don’t think investing needs to be complicated so I keep it as simple as I possibly can” – needs to be dished out to investors of their own funds.

I think the biggest contribution of Bogle was not the fact that its impossible to beat the market – its tough, but not impossible but showcasing the fact that fees has a very high impact on returns. Lower the fees, higher the returns – its that simple.

Vanguard’s own active funds charge a median fee of just 0.05%. This low fee ensures that the fund manager need not take unnecessary risks to generate Alpha.

Just to give a comparison with mutual funds in India, most of them charge on an average around 2.05% for regular funds and 1.20% for Direct Funds (Asset Weighted). Easy pickings in the past have meant that even post high expenses, many a fund manager has been able to handsomely beat the benchmark.

New rules combined with huge inflow of funds seem to rock the gravy train as funds will find it extremely tough to outperform the passive indices. Cutting down on fees is the easiest way to generate better performance, but why bother when funds are flowing into active funds like no tomorrow.

“Kitna deti hai?” was a campaign launched by Maruti to showcase our obsession with mileage. Then again, how can we be blamed given the high cost of fuel thanks to loads of government taxes. Every car manufacturer wishes to maximize the miles per litre. While a lot of savings come from optimizing the engine, one of the ways to add mileage is by reducing the drag of the vechile.

The higher the resistance a vehicle offers to the wind, lower the mileage. Car Manufacturers spend big money trying to optimize the design that reduces the same while still adhering to the overall design concept. A Formula 1 for example has the lowest amount of wind resistance but is unlikely to in favors if introduced as a family vehicle.

Friction in finance eliminates returns – higher the friction, greater is the reduction in return for every unit risked. Ritholtz Wealth Management offers Financial Planning and invests their clients money into cheap, low fee products.

But much of the savings they produce to the client are eliminated by their own fee which is a percentage that is many a multiple of the fees charged by actual money managers. This again is friction and the client finally ends up with much lower return.

The biggest fear of Universities and Research Labs are of their best and brightest weaned away from Campuses and Labs to Wall Street. After all, no University or Lab can compete when it comes to the pay Wall Street is willing to offer.

This pay though comes straight out of the pocket of investors. In good years, the fund manager takes not only a management fee but part of the profits as well. In bad years, he is more considerate and takes away just the management fee.

Do that for decades and the investor ends up with just a small part of the overall profit that has been generated using his capital. Mutual Funds aren’t that bad, but their Alpha contracting, the fees over time will eat up into significant returns.

Warren Buffett charges a minuscule percentage for managing the Billions he is in charge of. It’s been calculated that if Buffett had charged what is charged by much of the fund industry – 2% management fee and 20% share of profits, his investors would have stood to lose a lot.

Eliminating friction is a step towards achieving your financial goals faster. The lower the costs, better the return – its as simple as that. The reason to choose an Index Fund rather than active fund lie in the fact that identifying active fund that shall be the winners of the future is incredibly difficult.

Low Fee Active Investing is the path forward. Everything else is secondary.

The role of Incentives and what it means for your Retirement

There is this famous skin Doctor in Bangalore whose clinic is thronged by patients all-round the year. Being famous generally also means that one gets expensive but it ain’t so here, the Doctor Consultation fees is lower than what any other specialist anywhere shall charge.

But there is a catch – you need to buy the ointment he prescribes at the Chemist shop next door. The chemist dispenses the prescription which can be split into two parts. One is the actual ointment, an as I have experienced, this is not one easily available elsewhere. Second is a cold cream which is manufactured by a very famous multi-level marketing company.

You buy both and go back to clinic where the Doctor’s assistant mixes the same, labels it and then goes onto provide you with the next appointment date. While the Doctor fees is generally small, the charge for the ointment is extravagant – especially the cold cream.

You by now would have clearly guessed how the Doctor can afford the small fee and yet earn big. Is this Illegal? Of course, not. He doesn’t really compel you to buy at the chemist next door but I have tried and failed at sourcing the ointment elsewhere, so where else would you really go.

Second, once you accept this as part of the fees, you are okay for your main criteria here is not about paying money but getting rid of the disease that afflicts you.

Is this ethically or morally wrong?

What about if the Doctor charged a much bigger amount as his fee but then recommending medicine that is more affordable and not limited to that one store. Would that change the dynamics for his patients?

Or, what if he charges a low fee but prescribes high cost medicine and gets compensated not by the Chemist but by the Pharmaceutical company by way of tickets to seminars in distant countries or just a direct cut from the sales of the said medicine. Would that make any difference?

Let’s move the discussion to the world of Finance

Stock Brokers for long have chased their clients in an attempt to get them to trade more – higher the trading, more the brokerage. This is of course not in the best interest of the client, but targets have to be met, incentives have to be lapped up – so who is really counting.

While brokerage rates have fallen, even today many a stock broker dealer (the guy who places the order on your behalf) is determined not by how faultlessly he handles the transactions but how much brokerage he can generate.

Don’t we all have an Aunty or Uncle who after becoming a LIC agent would pressurize one to buy a policy which while actually not serving our real needs would help the Aunty or Uncle meet his targets and collect his cut of the cake.

Introduction of Unit Linked Policies took this to an extreme and while the trend has reduced a bit thanks to curbing of how much the agency can pay as commission, the highest and the worst form of financial misspelling still lies in the Insurance Field.

In an attempt to incentivize its distributors to sell its funds, Mutual Funds offer two kinds of payments – Upfront Commission and Trailing Commission

Upfront Comission is paid for any funds received – be they lumpsum or SIP. They range from 1.5% at the higher end to 0.25% at lower end with the Median upfront commission being 0.65%.

Trailing Commission is the commission paid on the value of your investment. This is to incentivize the seller for helping the client stay with the fund. It’s also a kind of ransom paid to ensure that the seller doesn’t take his clients money out at the end of the first year to only re-invest & hence obtain the upfront commission. This commission ranges from 0.75% to 0.25% with the median working out to around 0.50%.

Debt funds, a category of funds that invest only in Debt products with return comparable to Bonds on the other hand has way lower incentives. The incentives themselves depend on the product with Liquid funds which are favoured by corporates getting the least amount while Gilt and other longer duration products commanding a higher fee in recognition of the skills it takes to sell those.

“Show me the incentive and I will show you the outcome.” – Charlie Munger

Incentives aren’t just limited to the ones above. After all, when people complain that Tata Workshops don’t distinguish between the Taxi driver who is driving a Tata Indica and the owner of Tata Safari, Star Distributors cannot be satisfied with financial incentives alone.

A large mutual fund house for example takes its Star Distributors to Omaha to attend the annual pilgrimage that is the Berkshire Hathway Annual General Meeting. While the meeting itself is in recent years broadcasted live, there is a world of difference in attending it live versus attending it from the comfort of your room. Attending at the comfort of your own doesn’t give you the bragging rights compared to what you get when you attend it live.

It’s ironical that they are sent on a trip to Omaha given Warren Buffett’s own views when it comes to Investing. Speaking to CNBC, he said

“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”

How many advisors, whether they visit Omaha or not will dish out this advise to their clients? While its true that in the recent past, active funds have beaten the passive indices, with new changes, do you really think that they will continue to beat forever.

SBI ETF Nifty 50 is the largest fund out there thanks to it being the fund of choice for the Employees Provident Fund Organisation (EPFO). It is also the cheapest fund around and the one with the lowest tracking error.

Over a 3 year look-back, this fund is the 12^th best fund of 68 funds. Most of the 10 above this, the 11^th fund is its cousin – SBI ETF Sensex, we have only Axis Bluechip fund with almost all others ebing passive ETF’s.

Going further, I believe this trend will accelerate with more and more ETF’s and Index funds being in the top decile.

But ETF’s and Index funds have a problem – they are no one’s baby. So, regardless of the returns, barely any advisor will recommend the same to his clients. Over a 10 year period, the best performing large cap fund is Reliance ETF Junior Bees. Its AUM – a measly 515 Crores.

In the United States, this problem has been taken care of my Fee based financial advisors and wealth management firms who have succeeded in breaking the taboo of investing in simple and plain products. In India, you have better luck finding a needle in the haystack than finding a financial advisor who is fee based.

Fiduciary Duty: A legal obligation of one party to act in the best interest of another.

Fiduciary duty of an Investment adviser is similar in thought to the Hippocratic oath that requires a physician to uphold ethical standards. Keeping the objective of the client above oneself is the key trait of the Fiduciary duty.

Time and again, data has shown that Investors exit and enter markets at the worst possible moments. While one cannot time entry to perfection, when one exits in a panic, the reason is not just about loss of money but loss of confidence.

Mutual funds today are being pushed as the answer to all ills with all kinds of numbers floating around on what to expect. Rather than temper expectations which also leads to a better informed client, very long term historical numbers are used to suggest that one can expect to become rich by investing a very small sum today.

The primary reason for disappointment comes from unable to reach or beat estimations that one figured would be reached. When a product is sold with expectations of high returns, any deviation will result in the product being blamed rather than the message.

Recently I saw an advertisement from a fund distributor that saving just Rs.3000 per month could make one a Crorepati in 30 years assuming growth of 12% per year. There is nothing wrong perse with the above statement.

But what is missing and critical is the value of that 1 Crore, 30 years later. Can you buy what is worth 1 Crore today for the same price 30 years later?

In the US, over a 20 year period (1996 – 2016), tution cost went up by 200% even as general inflation itself went up by 55%. Quality education in India is becoming expensive by the day and given our inability to finance, we are ending up with students passing out of colleges without much of the knowledge and experience required by the Industry.

Tution cost for a two year post graduate degree from the Indian Institute of Management currently stands at 22 Lakhs. Add to this cost of living, cost of books, transport among others and we are quickly looking at somewhere in the 30 Lakh benchmark. Even assuming it grows at 6% per year, 30 years later, you shall be looking at something in the range of 1.75 Crores.

In the above advertisement, 12% return is the post expense return. What this actually means is that a regular fund has to generate 14.5% returns to get you 12% returns. Direct fund requires generating 13.5% returns while the ETF needs to generate just 12.10% returns to meet your 12% requirement.

What if instead, we assume that all funds can generate just 12% returns before expense. Assuming you were saving 3000 per month, what would you end up in the 3 different examples?

Even though the savings and the market returns were the same, the difference in returns is staggering. This is the act of “Compounding”. Returns and Fees both compound – one adds a positive flavour to your returns, another negative.

I am a strong believer in Active Investing and while Active Mutual Funds have had an exciting time, the days of strong out-performance vs the benchmark is more or less gone. The culprit may not be the rules as much as their own growth in assets which limits flexibility on what you can buy.

But that doesn’t stop funds from accumulating more and more for higher the AUM, higher the Income for everyone who is in the food chain.

Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther – Charlie Munger

At the Intelligent Fanatics website, a case study was recently posted on the site with a lot of real life examples of how human behaviour was moulded by the wrong kind of incentives. From selling more loans to get meet the incentive plan (sell less than 80% of goal & you had no incentives awarded) to classifying orphan children as mentally disabled since the subsidy by the government was $1.25 per day for an orphan versus $2.75 per day for psychiatric patients.

If my reward to sell a particular fund was a free trip to Omaha, would I really be concerned about whether the fund suited the client or not?

If you are saving for retirement which is 20 / 30 years away, the savings from fee alone can make a huge difference. Remember, at 6% inflation, a Crore wouldn’t go a long way 30 years from now – you will need at least 30 Crores to make the nest count.

Market performance is not something you can control, on the other hand the cost you pay to achieve market returns is very much in your control. The question is, Will you Act?

Fee always makes a difference to the outcome. Stop following the Herd

Till the establishment of the National Stock Exchange, anyone who wanted to buy shares approached brokers of the Regional Stock Exchanges who either bought the shares on their own exchange if it was traded or bought it on another exchange on which the stock got traded.

There were two kinds of fees that brokers levied. One was the brokerage which was anywhere between 3 to 5 percent of the transaction amount depending upon whether the stock was traded at the exchange where the broker was a member or on another exchange.

Of course, this was the known fees that were paid by the client. The unknown fees were that of the difference in price between where the share was originally bought or sold and the price reported to the client.

It was not a surprise that Regional exchange membership commanded mind-boggling prices. Most exchanges gave out a limited number of membership cards. The scarcity of the membership card combined with the opportunity to make a bundle meant that come rain or shine, prices of the membership card barely went down.

To compensate for the high fees, each member was allowed to bring in a few more authorized assistants into the trading ring. Even at exchanges where volumes weren’t really great, the price for becoming an authorized assistant wasn’t cheap.

Time and Tide wait for none and so it has been for the stock brokers. First came SEBI which restricted maximum charge that a broker could levy at 2.5%. Establishment of the National Stock Exchange was the real deal breaker when it came to membership prices. Operating on basis of Deposits only, NSE literally pulled the rug from under the feet of other stock exchanges.

Brokerage rates have been on a downward trend since then though establishment of Zerodha in 2010 with its per trade brokerage at first and later going in for free brokerage for delivery trades. Incidentally, the US seems to be catching the same bug with JP Morgan following the lead of Robinhood in offering free brokerage.

The key reason for falling brokerage was not because of the SEBI law which still held brokers could charge 2.5% but because National Stock Exchange removed once and for all the arbitrage held by brokers. Since becoming a broker was now easy and much of the deposit was refundable. Demand and Supply leveled the playing field once and for all.

Few days back, all hell broke through when Morning Star released its Morning Star Global Fund Investor Experience Report 2017.

India has a very good score in many aspects. 100% of mutual funds in India revealed their portfolio’s on a monthly basis, something that no other country in the list comes close. Indian Mutual funds also have the lowest time lag from end of month to release of portfolio holding details at 11 days. The worst is Hong Kong at 113 days.

The key reason for the anger lay in the section of Fee and Expenses. India saw a drop from its previous standing to now be part of the Below Average category. While Fees are indeed higher compared to other countries, Front Load not being present should have added value for they too are a part of the Expense Ratio, at least for the First year of investment.

Its thanks to SEBI in large part that today we are able to enjoy a low brokerage structure that is absent in most other countries. But it’s the same SEBI that seems to be the hurdle when it comes to opening up of the financial sector for competition.

While RBI restricts Banking Licenses making it nearly impossible to compete with existing banks, SEBI by way of minimum capital requirement has made it tough for competition to emerge.

In 2014, SEBI raised the Networth required to become a Mutual Fund from 10 Crores to 50 Crores. In one step, SEBI killed the competition that could have come up with interesting and new products. Over the last few years, we have actually seen a decline in the number of fund houses as small and non-viable firms looked for an exit.

Take for example, the United States where anyone can set up a Mutual Fund with Setup costs typically between $75,000 to $100,000. At the higher end, this is more or less 2x the Per Capita Income (PPP).

Indians are flocking to mutual funds like never before. The key reason is not just the strong advertising that showcases the advantages but the fact that the alternative asset classes was not delivering the goods.

Interest rates had fallen and with it being taxed at bracket levels, Fixed Deposits was not seen as appetizing. Real Estate which long had been and continues to draw investors hit a wall as after years of galloping returns, prices have more or less flattened.

During these times, Equity markets rose like a phoenix and rewarded those who were invested handsomely.

But asset classes don’t always move in a single direction. Equity markets have been going up like there is no tomorrow (these days, its mostly limited to large cap), the earnings which are not rising in the same breadth means that sooner or later, this rally too will fizzle out.

While bear markets are part and parcel of any stock market, paying excess fee can mean that your own returns are sub-optimal even though you may have had the knowledge that many others don’t when it comes to investing in equity.

With no new fund houses on the anvil, active funds in India have the upper hand. But that doesn’t mean that one has to pay through the nose for there are many a simple alternatives – Exchange Traded Funds (ETF’s) and Index funds which while not promoted can in the long term provide you similar returns thanks to their lower fee structure.

While an investor who is clueless about the world of finance may be easy to be misled, why are you, a person who knows better following the herd?

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