How Investors Can Avoid the Trap of Mutual Funds Mis-selling

June 14, 2023 Mutual Fund

Mis-selling of investment products has been occurring for many years in the financial services industry, and as a result, investors are frequently getting trapped. While SEBI laws may serve as a shield to safeguard investors’ interests, investors must still be aware of certain factors to reduce the likelihood of mis-selling.

Your bank relationship manager, broker, an investment advisor from various financial institutions, etc., may phone you on a number of occasions to let you know about an excellent investment opportunity that you shouldn’t pass up. The investment opportunity may be attractive since it frequently involves mutual funds and the prospect of higher returns, but it is crucial to protect yourself from mis-selling and allocate the funds to the right assets.

Many banks in the public and private sectors hold mutual funds or control the majority of asset management companies (AMCs). Banks may occasionally engage in mis-selling while selling the mutual fund schemes of their affiliated mutual funds. Although SEBI, the capital market regulator, checks if banks are resorting to mis-selling to push their mutual fund schemes, it is prudent to conduct your own due diligence on the suitability of the mutual funds for you.

[Read: SEBI Chief’s Warning to Finfluencers! Here’s What She Said….]

What is Mis-selling of mutual funds?

Mis-selling is where products or services are deliberately misrepresented by banks/financial institutions to customers/investors. In simple words, mis-selling occurs when you are given unsuitable advice, the risks are not explained, or you are not given the information you require, and you end up with a product that is not right for you. On the contrary, mis-buying occurs when buyers are entirely unaware of the financial product’s details and complexities.

According to SEBI, mis-selling is the sale of mutual fund scheme units directly or indirectly by making false and misleading statements. Moreover, mis-selling occurs when important information is omitted or concealed, risk considerations connected with mutual fund schemes are downplayed, or due care is not taken to ensure the mutual fund scheme is suitable for the client.

The unfortunate reality is that, due to the fierce competition in the financial services sector, some investment advisors driven by incentives offer the heavens to prospective consumers to reach unrealistic sales targets. Investors in mutual funds are tempted to churn their portfolios every three months, and inexperienced investors are advised to invest aggressively in equities without being informed of the volatile nature and market risks it carries.

Some common strategies used by mis-selling agents to lure in gullible investors are:

• Emotional context concerning the future of family, children, etc.
• Guaranteed returns
• Presents distorted data to claim superior performance of the scheme
• This is the best time to invest in the scheme, or you may lose on gains

Mis-selling is notoriously difficult to describe and pinpoint. However, it can be avoided if you understand your requirements, risk appetite and biases and learn about the financial product. In this article, I’m going to tell you how you can avoid getting into the trap of mutual funds mis-selling.

Here’s 5 easy ways an investor can avoid being a victim of mis-selling of mutual funds:

1. Ensure alignment with your financial goals

Investors may end up investing in mutual fund schemes that do not suit their financial goals. Investments in your portfolio have to be in line with your goals. For instance, equity funds are suitable for long-term financial goals, hybrid funds for medium-term and debt funds for short-term financial goals.

It is not a good idea to invest if a mutual fund is being pitched to you only on the basis of its historical performance or its potential for high returns. If you invest in mutual funds that are in line with your financial objectives, you can protect yourself against being mis-sold. Before making any investments, clearly define your S.M.A.R.T goals and prioritise them in terms of importance. Goal-based investing may assist investors in making suitable investments and keep them from getting caught in mis-selling traps to a large extent.

2. Do your own due diligence

Banks and various financial institutions may pitch multiple products to individuals through presentations, mailers, and other forms of communication. However, investors should avoid investing in any product basis only on this information. Investors must do their own research in the form of independent reading and research before investing. This may include a study of supporting documents to the claims made by the marketer in their original document. Or asking the right set of questions to get a better insight into the product.

For instance, Is there a lock-in period for the mutual fund scheme? What are the tax implications? What is the expense ratio? In today’s fintech world, where all information is easily accessible, it is also important to filter the accurate information and make informed decisions. Doing your own due diligence will protect you from the traps of mis-selling and enhance your financial awareness.

3. Don’t invest if you don’t understand

Investment decisions and returns are often framed as a comparison between two instruments. By comparing equity fund returns with those of bank fixed deposits, certain bank relationship managers may persuade investors to invest in equity funds. However, equity funds and bank FDs belong to different asset classes. It is not right to resort to a comparison between equity and debt asset classes, it’s like comparing apples with oranges. Basing the investment decision on the correct comparison will also help you to avoid falling for mis-selling traps.

Investors are often inclined to buy financial products despite a lack of understanding because of hearsay and investor biases such as herd mentality. Even if neither the investor nor the advisor is aware of the mutual fund scheme’s suitability or investment objective, they will nevertheless choose to acquire in order to please a friend, neighbour, or relative. Some investors succumb to emotional biases and make investments that are not right for them solely because a friend or relative suggested it.

Additionally, some investors convince themselves that if a large corporation or bank is selling it, it must be good because SEBI has approved it. However, based on risk tolerance, investment horizon, and goals, one must make sure the investment product is appropriate for their needs. Investing in a product without fully understanding it is a recipe for disaster.

4. Don’t be greedy

Investment mistakes are simple to make when greed takes precedence over rationality. Many people, overwhelmed by the lure of a significant return, put their money into unknown financial products without even knowing what they are investing in.

Often there is a mention of the past returns of a mutual fund, and then it is projected that the fund will give a certain amount of returns. However, what one must realise, though, is that a fund’s returns will fluctuate considerably depending on the prevailing market situation. Several categories of equity funds are also very volatile; hence, novice investors may avoid investing aggressively in equities. Any investment decision should never be based only on past returns, as it doesn’t guarantee future performance. It only helps to check if the mutual fund scheme has performed well consistently over various market cycles against the benchmark and peers.

5. Evaluate the risk profile

The mutual fund riskometer should be used to assess the risk in a mutual fund. You learn about the risk connected to mutual fund schemes. The riskometer, for instance, divides the risk associated with mutual fund schemes into low, low to moderate, moderate, moderately high, high, and very high categories.

For instance, market-savvy investors with high-risk tolerance may opt for equity funds with higher risk for higher returns. Conservative investors, on the other hand, may pick mutual funds with low to moderate risk, such as debt funds. Simply said, before investing in mutual funds, consider the riskometer of the fund and make sure it matches your risk profile rather than following the advice of bank relationship managers. Risk tolerance levels must be clearly defined and used to guide investment decisions.

This article first appeared on PersonalFN here