They Hide Facts That Could Reduce Their Revenue

Let me start with a short story. I was a small investor then. One day, I discovered an article that spoke about a Basic Services Demat Account. On further research I found a circular issued by the Securities and Exchange Board of India, that described the entire facility. To my awe, I realized that had my broker told me about this, I would have had to pay a reduced fee for maintaining my account with them. Here is a snap of the circular.

On asking my broker convert my account they said that I would have to sign a form, which I agreed to. They handed me two forms. One was the BSDA account conversion form and the other was an ECS mandate. On asking why an ECS mandate was required, the broker mentioned that it was their policy get it signed along with the BSDA application. I questioned that and asked them why they would need access my bank account for an account conversion. They were rigid and I had to escalate a complaint to finally get my account converted.  The first thing to notice here is that the broker never ever spoke of this kind of account. Secondly, they presented some unnecessary baggage when I insisted on the conversion.

Many years passed and I turned from a trader to an investor. I executed only a few trades every year and held long-term positions. One fine day I received an email from that same broker stating that my account was being converted to a dormant one because of my inactivity. Whenever I wanted it back,  I would have to reach out to them and they would try to get my account activated within one business day. This could mean a lost trading opportunity for me! This time I wrote to them asking whether their business policy was only to entertain traders who generated enough commissions for them and whether they were unwilling to entertain long-term investors. I asked them to state this clearly in a reply which I would certainly take forward to the regulatory authorities. After the exchange of some emails, my account was reinstated. I did not expect this from one of the leading broking houses in our country and since this event, my faith in them has certainly diminished. 

They Need Commissions, Not Your Prosperity
It is easy to notice how often brokers will encourage you to trade on their recommendations. Please bear in mind that whether you make a profit or not, they earn a commission from each trade you make. And so, it is in your best interest to judge whether to execute a trade or not. Brokers will also discourage withdrawal of funds from your trading account. You withdrawing your funds means a reduction in their account size, and a reduction in capital available for trade, which translates to lesser commissions. They will want you to reinvest your profits and will show you a huge corpus, all on paper. What is the use of funds which you cannot spend?

The Motive Behind Their Recommendations Might Not Be Transparent
It is easy to notice that most of the recommendations offered by brokers are on the buy side. Many brokers are subsidiaries of investment banks and it is obvious that it is difficult to write negatively of a company who might be their client, or possibly a prospective client. Secondly, there is another advantage to buy recommendations. Anyone who has money can buy a stock, but not everyone can sell a stock. You will need to own a stock in order to sell it. Therefore, at any given point of time, the pool of prospective buyers is far larger than the pool of sellers. Which is one more reason why we see more buy recommendations than sell. There could also be other vested interests behind their recommendations since financial institutions, banks and corporate bodies maintain close ties.

They Recommend Funds That Feed On Your Money
Ever wondered how mutual funds finance their operating costs? Where do they get the cash if you sell your holdings? Do they have to sell your portion of stocks? If not, then they have to pay it from their cash reserves, which is funded by your money. Who pays for all their advertising? Yes, all of this is discounted in the NAV which is the price you pay for one unit of the fund. Let me explain with an example.

Let's say the fund wants to buy shares of company A which is currently trading at Rs 100 per share.

The fund has a corpus of Rs 1,00,000 and therefore will buy 1,00,000/100 =1,000 shares of company A. The fund issues 50,000 units to the public for purchase and therefore each unit will be priced in the following way :

Price of 50,000 units = Rs 1,00,000

Price of 1 unit = Rs 1,00,000/50,000 = Rs 2.00

But then they have to cover their expenses. So they factor these in, and the NAV, which should have been Rs 2, can be dropped to Rs 1.50, leaving out 50 paise for every 2 rupees you invest to cover their costs. Assuming that is the price you are willing to pay for their expertise, let us look at the next question.

Their Interests And Yours Might Not Be The Same
What is the assurance that the fund manager's only intent is to outperform the market? We rarely see them outperforming though. Moreover,  is performance alone a good indicator of a fund manager's skill? What risk is he exposing us to ? Where do they show the risk calculations? It's all about returns, returns and returns everywhere.

In many cases, the compensation of the fund manager is not a function of his performance, but a function of the value of assets under his management. Therefore, it is in his best interest to demonstrate returns of his investments to potential investors, masking the risk component that is applicable to those same investments. This poses a greater cumulative difficulty. As the corpus of his fund increases, it becomes increasingly difficult to manage them.

It is wise to realize that though the entire equity market comes with a share of risk, the quantum of risk is not equal across the spectrum of stocks. And therefore, investing the same amount of money in two different stocks poses the investor with two different risks. An awareness of this fact will help an investor choose his stocks not by looking at return alone, but in conjunction with the risk it carries and therefore helping him to evaluate the return per unit risk across his investments. It is true that the risk of an entire portfolio is also a fair estimation of the risk that the investor accepts when investing in a fund, but that information is also not highlighted for the awareness of the investor. It is usually found in some corner of the fund prospectus and stated in technical terminology when it should have been made available to the lay investor, highlighted and well explained.

They Aim For The Wrong Thing

The next hurdle is the relative performance trap. Typically, funds are compared against an index and/or against other funds. This is a blatant example of misleading potential investors. The only reason why an investor should trust a manager with his money should be the potential value of the stocks that the fund is invested in. In trying to outperform an index or another fund, it is easy to lose sight of the value of the stocks being chosen as investments. Other fund managers are also doing the same and therefore, the situation ends up with a group of fund managers each trying to outperform the other. As a result, everyone ends up with mediocre returns and the economy suffers. It is only the brokers who benefit from frequent churning of the portfolio.

Their Opportunities Are Limited

There are many value stocks available in the market which cannot be picked up by any mutual fund. This is because of the sheer size of their investments. In keeping with their restrictions, funds are unable to invest in relatively illiquid stocks, even if their potential upside is huge. Let us look at another example.

Say the corpus of the fund under management is Rs 300 crores. The fund decides not to allocate more than 5 % of their corpus in any one stock. That leaves them with a maximum of 15 Cr to invest in one stock. The next restriction they face is that they have a cap on the maximum percentage of outstanding shares of a company they can buy. Which means if the cap is, say 3 % and a company has 15 lakh shares being transacted in the market, they can buy a maximum of 45,000 shares. So in this case, the company has 15 Cr to spend, and a max of 45000 shares to buy. Which means each share will have to cost Rs 3,333.00 in order to exhaust the entire corpus of the investment. Value stocks come for a far lesser price which leaves the fund handicapped. Either they have to invest a minuscule amount, or they have to forsake the opportunity.

In contrast, an individual investor, who knows how to find value stocks would easily be able to transact in these shares on a personal capacity. There could be minor liquidity issues, but given the size of average investment in one stock, there would not be much difference in the price at which a trader would complete his purchase.

It is therefore in the best interest of the investor to be aware of the complete picture of what he is getting into, before investing his hard-earned money. It should be our endeavour to educate each other so as to make the most of the opportunity of investing.

Do you have another experience to share? Do you know of any more pitfalls? Let us know with your comments!