There’s a new rumour in town. And it says mutual funds might soon be able to charge a fee based on how well they perform — a performance fee. In today’s Finshots, we explain why this might be a huge deal.

The Story

The Mutual Fund industry operates on a simple premise.

They will tell you regular investors have little know-how about the complexities inherent in stock markets. They’ll convince you that you’ll always be at a disadvantage since you don’t have access to information that could help you optimise your choices. They’ll even contest that you cannot interpret this information even if you somehow managed to get your hands on it. Instead, a better approach is to simply let them manage it for you.

They’ll take your money, divert it to a common pool — with funds mobilized from other investors like you and they’ll invest this corpus in handpicked stocks to offer you outsized returns.

All this for a small fee.

And the way things stand, mutual funds charge a fixed fee which is typically 1–2% every year.

But…there’s a tiny problem with this.

You see, it doesn’t matter if the fund manager burns the midnight oil and picks a bunch of fantastic stocks. Or whether they choose a bunch of duds by throwing darts at a board. Whether they win or lose, they’ll simply charge the ‘fixed’ fee. Or as Warren Buffett put it, “Performance comes, performance goes. Fees never falter.”

Now that doesn’t sound like a great thing if you’re an investor, right? You will have to pay a fee even when you don’t make any money yourself.

Also, there’s another problem here. If you think about it, there’s really no incentive for the fund manager to put in the hard yards and look for hidden gems in the stock market. Because even if they deliver supersized profits, they can’t charge a higher fee. Their upside is limited.

So fund managers might shy away from trying too hard. They try and be as conservative as possible with their stock picks. Their first focus is ‘protecting’ their career. And the maxim is “It’s better to fail conventionally than to succeed unconventionally.”

They don’t deviate too much from their benchmarks such as the Sensex 30 or the Nifty 100. They replicate them to a large degree. And even if they underperform, which they do, it’s okay because everyone else is failing too. For instance, if you take a 10-year period from 2012 to 2022, you’ll see that 68% of funds that invest in large blue chip stocks fail to beat their benchmark. See what we mean?

The poor investors keep paying a fixed fee for the ‘privilege’ of this underperformance.

So, how can we fix this problem?

Well, some people think that we change the incentives. Get rid of the fixed fee and bring in a performance fee. Tell fund managers that if they deliver supernormal profits, they get a share of the cut too.

Now the way this typically works is that there’s a hurdle rate that fund managers will first need to beat. Say 8% which is what a safe fixed deposit might offer. Now imagine that the fund manager delivers a solid return of 15%, they’ve now beaten the hurdle by 7%. So they’re entitled to take a cut here. If they charge 20% on this excess performance, they pocket a cool 1.4%.

That’s a nice payday.

What if they fail to beat the hurdle?

Well, they’d have to make up for the loss first. So if they managed only a 7% return, the next year, they’d have to make at least 9% to be eligible for a performance fee. It’s what Warren Buffet did when he first started managing money in the 1960s.

In a sense, it’s skin in the game. The incentives are aligned. The fund manager makes money only if they’re able to make money for the investor. If they fail to deliver, they don’t make money either. There is symmetry in the process. And the belief is that fund managers will put in more effort for funds that give them this sweet sweet upside.

This sounds quite exciting from an investor’s perspective, doesn’t it?

But be warned, it’s not a perfect solution. Performance fees come with their own set of problems.

For starters, there’s one argument that the hurdle is often too low. See, the objective of a fund manager is to beat the index such as the Nifty 100. But if you simply take the rate of inflation or the fixed deposit rate as the metric to beat, then that’s setting the bar too low. They might still continue to underperform the Nifty 100. Yet, they’ll make money for themselves.

On the other hand, fund managers can also get greedy in their quest to capture a big performance fee. They might end up taking on a lot of risk. And because they’re judged every year, they might simply chase the hot thing. They’ll ditch prudent processes in favour of quick money. And things can turn ugly.

Now let’s say you set all these arguments aside. Both the good and the bad and ask the one question that really matters — do mutual funds with a performance fee perform better than ones with a fixed fee?

Well…the answer is a little tricky because there isn’t really a lot of data out there. But let us tell you what we found.

Internationally, when researchers looked at data in the EU from 2001 to 2011, they didn’t find evidence to indicate that performance fee-based mutual funds delivered superior returns.

And while there’s no way to make a similar comparison in India, we can still try. You see, there’s something called Portfolio Management Services (PMS). Think of this as an investment fund for rich folks. There’s a professional fund manager who picks stocks and manages your money for you. And most of these PMS funds run on a performance fee model. So we could compare their performance to the humble fixed-fee mutual fund.

And when LiveMint crunched the numbers, they found something shocking — 6 out of 10 PMS funds failed to beat the mutual funds over a 5-year period. Ouch.

Looks like the performance fee wasn’t incentive enough to deliver high returns, eh?

Anyway, it’s still too early to say whether performance fees will make their way into mutual funds or not. Or whether it’ll be a mix of both a fixed fee and a performance fee. But we thought it’d be a good idea to lay it out here for you. Just in case.

Until then…

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‌Ditto Insights: Why Millennials should buy a term plan

According to a survey, only 17% of Indian millennials (25–35 yrs) have bought term insurance. The actual numbers are likely even lower.

And the more worrying fact is that 55% hadn’t even heard of term insurance!

So why is this happening?

One common misconception is the dependent conundrum. Most millennials we spoke to want to buy a term policy because they want to cover their spouse and kids. And this makes perfect sense. After all, in your absence you want your term policy to pay out a large sum of money to cover your family’s needs for the future. But these very same people don’t think of their parents as dependents even though they support them extensively. I remember the moment it hit me. I routinely send money back home, but I had never considered my parents as my dependents. And when a colleague spoke about his experience, I immediately put two and two together. They were dependent on my income and my absence would most certainly affect them financially. So a term plan was a no-brainer for me.

There’s another reason why millennials should probably consider looking at a term plan — Debt. Most people we spoke to have home loans, education loans and other personal loans with a considerable interest burden. In their absence, this burden would shift to their dependents. It’s not something most people think of, but it happens all the time.

Finally, you actually get a pretty good bargain on term insurance prices when you’re younger. The idea is to pay a nominal sum every year (something that won’t burn your pocket) to protect your dependents in the event of your untimely demise. And this fee is lowest when you’re young.

So if you’re a millennial and you’re reading this, maybe you should reconsider buying a term plan. And don’t forget to talk to us at Ditto while you’re at it. We only have a limited number of slots everyday, so make sure you book your appointment at the earliest:

1. Just head to our website by clicking on the link here

2. Click on “Book a FREE call”

3. Select Term Insurance

4. Choose the date & time as per your convenience and RELAX