A dent in mutual trust

It is tyranny's disease, to trust no one,

So, when a man has no reason to trust himself in the complex maze of investing,

He trusts in the investment company that runs the mutual fund.

For the investing masses who are not sophisticate,

There is a godfather willing to give them special love,

He will use the concept of trust as a vehicle for commercial transaction,

And set up various funds and schemes that will manage investment for the benefit of beneficiaries or contributors to the trust that’s set up,

That is how he will grow people’s finances incrementally, upward day by day.

So, the first step will always be the investment company (godfather) stepping into the shoes of being a settlor (sponsor) and creating a mutual fund (the trust),

Next, he has a plan to put an angel on the trust’s shoulder, to be right there all the time,

Enter the ever watchful watchdogs, the anointed trustees to the fund, on whose watch nothing purportedly could ever go wrong with the fund,

Now to grow what is sown, and to sweep the fund off its lethargic feet, the sponsor next appoints an investment professional, the Asset Management Company (AMC), to manage the fund resources,

Aha! The ground rules are set and the match begins; enter you and me, the beneficiaries of the trust (mutual fund), who buy into the fund by purchasing its unit certificates and parting with our precious savings.

They say a free lunch can only be found in mousetraps,

So, if they (sponsor, trustee, AMC) grow for us our money – what do they get out from it?

A fee!!! Who gets the fee? The AMC. Who pays the fee? The so called beneficiary mutual fund certificate holders,

Wherever there is a fee income to be earned, there is a possible corruption of motivation in actions; I don’t say it – everybody knows it, I just explore it here in this context,

Even before one looks at the fee angle for inspection, there is another possible conflict of interest to ponder over; the sponsor, the trustee and AMC are all different subsidiaries of the same entity, thus opening avenues to exploit capacities for personal or corporate benefit,

But that is a different story to tell another day; today, it is a critique of how AMCs (aka fund managers) may have a conflict because of the way they get paid.

Fees to AMCs are paid as a percentage of assets under management, those monies that you, I and others have brought in to the fund,

No guess then that an AMC’s primary incentive will be to attract as much money into the fund as is possible for them to garner from investing public,

Mutual fund investors choose funds that have better than average performance numbers in peer group of available funds,

On the other hand, most mutual fund investors also follow a buy-and-hold strategy; once they have invested in a fund they stick with it for awhile no matter what;

For they have been taught that a buy-and-hold investment strategy is indeed an effective long term strategy;

Resultantly, a mutual fund that outperforms the market will see funds flood in as investors choose it over other mutual funds;

On the other hand, underperforming funds will see money flow out of the fund at a much slower rate; overall, the rate of inflow to a successful fund being much higher than the outflow from an unsuccessful one.

Arguments cited above now allow us to move into the next phase of exploring the fund manager conflict of interest with mutual fund investors,

It is in the fund investor's best interest to make sound, sensible investments that have a good probability of paying off, with only a small chance that the investor suffers a large loss,

On the other hand, it is in the fund manager's best interest to make highly risky investments that create the potential greater returns and better performance for large inflows of money into the fund,

So, what kind of risky strategy might a fund manager follow? Over-concentrating the fund’s holdings on a few securities in the hopes that one will pay off big would be one example strategy,
Investing a disproportionate amount of money in highly risky small-caps, foreign securities, or various options and derivatives would be another,

None of these investment choices are inherently bad, but if the goal is to increase the risk so as to increase the chances of a high return, then this is probably contrary to the interests of the fund's investors,

One surmises then that the fund managers will be rewarded if the fund does well, and on the flip side they are not punished nearly as much for failure (fund underperforming) as they are rewarded for success, because investors will show a disproportionate resilience to absorb losses for a while,

The ultimate result may gyrate to a situation where the fund manager assumes greater risk while investing with fund money, far afield to the end that investors’ best interests get pursued (a fiduciary responsibility) and to the effect that their fees earn them bigger pay checks and fatter year-end bonuses.

Professional men, they have no cares; whatever happens, they get theirs,
Such is the rue of many an investor who have lost their shirt and pants,

Oh! But to be fair, there are also many fund managers who never dent the mutual trust,

And always trade in the best interests of their unit holders, and not just expropriate their investors’ money.