If your investment ain’t broke, don’t fix it

The grim fact of the matter is that mutual fund distributors make are notorious for pulling this stunt. While one must not generalize --- there are the honest folks out there --- but the unscrupulous ones far outnumber the more conscientious ones. Anyway, there is easy money to be made by getting the investor to invest in a new scheme rather than letting him stay invested in an old scheme. The commission on selling a new scheme is much more than that earned through letting the investor stay invested in the old scheme. Depending on how big the distributor is, the commission is between 2-4% of the amount invested. In comparison, if the investor stays invested, the trail commission earned is typically less than 1% p.a. Hence it is in the interest of the distributor that he gets you to invest in the new schemes that keep coming out. However, the investor may not always have fresh money to invest? So what is the simplest way out? Get out of the old schemes and get into new ones.

The industry jargon for this is churning. Of course, the investor knows it as 'reorientation'.

Let's see how it pans out in terms of numbers. Lets say an investor invests in Rs 50,000 in a scheme. He pays an entry load of 2.25%. He stays invested for five years. Assuming that the scheme earns a return of 12% per annum at the end of five years, his initial investment of Rs 50,000 has grown to Rs 86,135. Now lets consider another investor, who churns his investments every year, meaning at the end of the first year, he sells out his investments in a mutual fund scheme and invests in a new mutual fund scheme and repeats the process every year. Every time he gets out of a scheme and invests in a new scheme, he needs to pay an entry load of 2.25%. Assuming he also starts out with Rs 50,000, then his investment at the end of five years would have amounted to Rs 78,640. Hence the first investor ends up earning 9.5% more by not churning and sitting on his investment. I have used a rate of just 12%, were it to be in the 30s or even 40s, imagine how large a difference that would make.

And as time progresses the second investor loses out more. For example if you take a ten year period, the differential climbs to over 22%.

So the next time you are entreated to invest in an NFO under the guise of reorientation, ask yourself one question --- is my investment broke? If not, don't fix it.

- Sandeep Shanbhag