How To Identify Incentives In Investment Products?

In the last article we looked at 5 variables that will decide how much wealth you build. They were –

1. Returns – higher is better, but carries risk and not totally in your control

2. Time invested – longer is better

3. Taxes – lower is better

4. Costs – lower is better

5. Amount you invest – higher is better

Let’s see how different investment ecosystem participants can manipulate our perceptions of the above variables to meet their own objectives, which may or may not align with yours. Let’s look at the two big variables – returns and costs.

Returns and future return expectation is where most of the mumbo-jumbo in misleading investors happens. It is the easiest metric to manipulate as at some level we all like good dreams. When it comes to returns the most important factor is whether a return is audited or not. A mutual fund or ETF returns are audited returns. Investors in those funds did actually get the returns shown in the history chart. A thematic basket return or a backtest return, however, is not audited. But, because we are so conditioned to seeing actual fund and ETF historic returns, that when someone presents us with a historic return we believe it as real. You have to take it on faith that the portfolio manager running the thematic basket or backtest has actually accounted for all costs correctly.

In my experience, most thematic managers underrepresent costs by a huge amount. In un-audited historic returns the portfolio manager also has the incentive to showcase the best return possible by building the strategy to match what happened in the past. Be prepared to be dis-illusioned if you buy into such a strategy.

In the investment ecosystem only the investor pays fees or cost which as we know above reduces your overall wealth outcome. Your total cost – trading, research, subscription, expenses etc – are the revenue for the remaining investment ecosystem that provides these tools to you. To maximize their revenue investment ecosystem participants will try and increase your costs – ideally in a way that it is not reflected in your returns so you never make the connection. To see it clearly let’s look at Mutual Funds and stock trading. Your Mutual Fund returns are net of expense and fees, so the return you calculate using Mutual Fund NAVs is the true return you got. In trading the transaction costs and annual maintenance fees and all the other transactions related taxes are not captured in price returns and thus making it seem like a cheaper wealth building option. They are not even shown in your net worth on a broking dashboard.

I had a young employee in our office trading with Rs 1 lakh and would always talk about how cost was marginal at Rs 20 per trade till he actually sat down and did the math to realize that in the FOMO and fear frenzy he did 112 trades last year i.e Rs 2,240 in transaction expenses i.e ~2.24% gone in transaction costs. This is before even accounting for the short term capital gains taxes all that trading caused. The point is not that your trading costs will always be higher than Mutual Fund expense ratios – just that you should always know your complete cost structure, even if it is hidden and not shown clearly upfront.

Finally, always account for human capital cost incurred. If you need to spend 10 hours a week to trade while using other options like funds or ETF would be 1 hour a week, that is one work day saved per week. How much would you value that time in skills gained and lifetime earnings?

You get the drift. When you see an investment product – don’t just look at what they are selling. Think deeply about how the product impacts the five variables above. Ask questions if the information is not easily available. And always keep track of real returns – after costs and taxes.

Kuvera.in is a free, AI-powered platform to plan your financial goals and investments.