Mutual fund distributors like to get investors to invest into new schemes. This is primarily because distributors earn a greater commission by getting an investor to invest in a new scheme instead of letting him stay invested in an existing scheme.
A mutual fund distributor makes a trail commission of around 1%, if the investor continues to stay invested in the scheme. On the other hand if the investor invests in a new scheme the distributor is likely to make 2-4% of the amount invested as commission.
Let us consider an investor who invests Rs 1 lakh (Rs 100,000) in a scheme. Assuming that it is an open-ended scheme, the investor has to pay an entry load of 2.25%. 2.25% of Rs 1 lakh works out to Rs 2,250 and this is paid as an entry load. The remaining Rs 97,750 gets invested into this scheme.
The scheme gives a return of 15% per annum and the investor stays invested in the scheme for a period of five years. At the end of five years, the initial investment grows to Rs 1,96,610.
Let us consider another investor who invests Rs 1 lakh in the same scheme. As is the case with the first investor, Rs 97,750 gets invested, in this case as well. But unlike the first investor who stays invested in the scheme, this investor gets out of a scheme at the end of the every year and invests in a new scheme.
Every time he gets out of an existing scheme and invests into a new scheme he has to pay an entry load of 2.25% on the amount he invests. This investor also earns a return of 15% per year and so his initial investment at the end of five years amounts to Rs 179,503.
The first investor has made 9.5% more than the second investor, even though both the investors earn the same returns. This is because every time the second investor invests in a new scheme he pays an entry load of 2.25% of the amount invested. Hence, the higher expenses of the second investor leads to him accumulating a lesser amount.
Some mutual fund distributors in order to sweeten the deal offer 'cash back' to investors who invest through them. This is a throwback from the days when agents of the Life Insurance Corporation of India, used to give cash back to individuals, who used to take policies through them, from the commissions they earned by selling the policy.
Let us say a distributor gets a commission of 2.5% on the amount he gets invested in the new scheme. Of this, he shares 1% with the investor, keeping the reaming 1.5% for himself. Assuming that the investor invests this 1% in the new scheme as well, this still is not a good deal for the investor as this 1% is not enough to take care of the entry load of 2.25% that an investor pays, every time he invests in a new scheme.
Let us consider a third investor who gets cash back of 1% every time he invests in a new scheme. This 1%, too, he invests in the new scheme. He exits an existing scheme at the end of the year and invests in a new scheme. Assuming he starts with Rs 1 lakh and earns a return of 15% every year, similar to the two investors before him, at the end of five years he ends up with Rs 186,496.
He is clearly better off than the second investor, but much behind the first investor who simply holds onto his investments. This, as is mentioned above, is primarily because the commission is not enough to take care of the entry load he pays every time he invests in a new scheme.
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