Beware! Direct mutual fund plans are great but they have a dark side, too

At a recent Association of Mutual Funds in India (AMFI) conference, SEBI chairman Ajay Tyagi exhorted mutual funds to promote direct plans. He said direct plans offer lower transaction costs, more transparency and reduce chances of misselling. Direct MF plans have some loopholes which defeat some of the said benefits. SEBI needs to address them post haste.

The genesis of direct plans was to offer a lower cost product to knowledgeable and sophisticated investors, either institutional or otherwise. Direct plans can also unbundle distribution and advisory costs. On the other hand, regular plans of mutual funds have the distribution commissions embedded and hence, the expenses are higher by that extent.

However, the intent of direct plans was never to entice individual or first-time investors to mutual funds with promises of higher returns. That is currently happening now in many underhanded ways. SEBI should first plug these loopholes before urging the MF industry to promote and advertise these schemes.

First, SEBI should properly enforce its advertising code. Currently, several registered investment advisors (RIAs) are promoting direct plans by projecting future returns. Often, these projections are shown anywhere between 10 and 18 percent. This is a direct violation of the basic principle that future returns cannot be projected and the SEBI advertising code. It is misselling.

Second, some RIAs use the sales line that investors can save up to 1.5 percent annually using direct plans. This difference in the returns between direct and regular plans is projected into the future. A prominent RIA advertises that with the 1.5 percentage point difference, investors can earn an additional Rs 25 lakh in 25 years. However, less than five percent of mutual funds schemes have a 1.5 percentage point difference in direct and regular plan returns. The difference can be as low as 0.02 percentage points, as it is for some equity funds. This is another example of mis-representation.

Third, there is a huge conflict of interest. Some mutual funds have started offering a portion of marketing budgets and investor education spends to RIAs selling direct plans. A recently launched direct plan platform made it a pre-condition for mutual funds to commit a minimum annual budget for featuring their schemes as a top investment idea. Aren’t RIAs and such platforms supposed to give unbiased advice? SEBI needs to ensure that there be no commercial arrangement between the manufacturer and the advisor (or their group entities) to avoid this conflict of interest. It should also prevent the misuse of investor education budgets for such purposes.

Fourth, mutual funds are organising events (for example, a World Cup screening with cocktails) for some of their direct and potentially direct investors. Some mutual funds have also started offering kickbacks to large investments in their equity funds by direct investors in form of marketing spends to group companies or even to the investor themselves. How the clock has turned back with direct plans! SEBI should make such payouts an audit point and penalise any such violations found strongly.

Fifth, some mutual funds are subsidising their direct plan costs from regular plans. Take, for instance, the separate teams set up by mutual funds to sell direct plans. Usually, the distributor of a mutual fund bears the client acquisition cost, advisory cost and part of the servicing costs of investors.  When a mutual fund sets up a direct sales team, all these costs get transferred to the fund itself. So logically, these costs in such a direct sales set-up should be borne by direct plan investors.  However, currently this is being borne by regular plan investors as per the regulatory definition. SEBI should change this. All acquisition and servicing costs for direct investors should be borne by only by direct plans. This will be fair and equitable rather than the current mis-accounting.

Every positive has some negatives.  This is true for direct plans also.  In the long term, a healthy investor fraternity for the mutual fund industry can be created on the back of robust and fair practices of strong advisory rather than creating regulatory arbitrage on expense structures and enticing investors on the premise of such under-hand practices.

(The author is a consulting editor with Moneycontrol. Views are personal)

(Disclosure:  Network18 offers mutual fund transaction services through its Moneycontrol Transact App. The app currently does not support direct mutual fund transactions.)