Can we trust mutual fund AMCs? Is stock investing a better choice?

A reader asks, “I have been continuously investing in MF for the last 6+ years. My brother tells me to invest in direct equity instead of MF for the main reason that the fund manager’s decisions can be driven by their relationship with the company or some conflict of interest. I buy direct equity in chunks but prefer mutual fund investing as mainstream. How much of this is true? Is this something we have to worry about while investing in active funds?”

Just as I was about to reply, this news broke: “Sebi fines Kotak AMC, its MD Nilesh Shah and 5 other officials for violation of rules“.  Fixed Maturity Plans of the AMC were extended against SEBI rules to prevent the default of Essel group bonds. This extract from the order is of particular importance.

“By not taking investment decisions solely in the interest of unit holders, not rendering high standards of service, not exercising due diligence, not ensuring proper care at the time of investment by assessing the adequacy of the collateral, not recording of the rationale as to how 1.6/1.5 times security cover is adequate collateral, (and) not assessing the credit quality of the underlying bond and repayment capacity of the issuer in the investment rationale, the noticees (Kotak AMC and its senior officials) have allegedly violated… mutual fund regulations,”

Franklin Templeton is also guilty of falsely pacifying unitholders that “all is well” when corporate investors were busy redeeming along with some senior AMC personnel including board members and trustees. See: SEBI imposes ₹15 cr fine on Franklin Templeton, 8 others over wound-up schemes.

The Axis MF front-running case is a bit different as the AMC is accusing its own fund managers of illegal actions.

The message should be clear, be it the AMC or the trustees, we cannot blindly trust anyone to always act in our interest. So does this mean direct equity is a better choice?

All companies have their own share of scams, incidents and whistleblowers (Asian Paints, Infy etc). The risks of managing a direct equity portfolio are also higher for the typical retail investor. It is no rocket science but experience in the stock market comes only after a few hard knocks and not everyone can afford it.

The web of scandal has also touched RTAs (Karvy) and market curators (NSE).

The simple and clear truth is, that all entities in financial services care about themselves first. Retail investors are the last in the pecking order.

Yes, mutual funds are structured in a “safe” manner as trusts. There are enough compliance safeguards in check, yet AMCs getting fined for breaches is a routine year-round affair.

A mutual fund portfolio is just as reasonably safe as a stock portfolio. Both have several factors beyond the control of their investors (at least the small ones) and we have no way to tell what drives the decisions of active fund managers. All we can do is hope/pray that most of them are for our benefit – the odds of which are quite reasonable.

This is why diversifying across 3-4 AMC is essential particularly as our networth grows. Over a 20-30 year investing period, one of the AMCs we are investing in could be hit with some scandal! The same is also true of direct equity or insurers or banks! We can run, but we cannot hide!

Perhaps index funds are relatively a safer place for investors. Not because they are passively managed but because, at least for now, the AUM is low. Index funds are subject to curation risk! See: Should I exit Nifty Next 50 because of Paytm, Zomato and Nykaa? So there will always be something to worry about!

So what should investors do? Avoid extreme reactions. Both blind trust and paranoia are harmful. Diversification across mutual fund AMCs, direct equity (if that is your cup of tea) and other asset class is the only rational step we can take along with constant vigilance. Then we stop worrying because beyond this, it is up to luck and prayer.