Despite being explicitly prohibited, the practice of 'rebating' or 'passing commission' continues to be rampant in the mutual fund industry.

Simply put, mutual fund distributors and investment advisors remit a part of their commission earnings back to the investors thereby 'rewarding' the investors for making investments through them.

From the distributor's perspective it is an opportunity to retain his clientele; on the other hand, the investor makes some money on the side (which he is legally not entitled to).

Before we discuss if the practice of accepting rebates is worth the investor's while, let's find out how the rebate mechanism works. Generally rebates are computed as a percentage of the distributor's income.

For example, if a distributor makes 3% upfront commission on a lump sum investment in a diversified equity fund investment, he pays the investor about half of the same, i.e. 1.5% of the amount invested. Hence investing Rs 20,000 in a diversified equity fund could fetch you a rebate of Rs 300.

Now let's take an example to understand how much an investor accepting rebates really stands to gain. Suppose the investment amount is Rs 50,000 and rebate offered is 1.5% on the same, i.e. Rs 750.

Consider two situations. The first one where no rebate is being offered and secondly when the investor gets a rebate. We shall assume that the rebate amount is reinvested in the fund. Also the mutual fund charges an entry load of 2.50%.

Hence in case 1, the 'real' amount working for the investor is Rs 48,750 (Rs 50,000 minus 2.50%); in case 2, the amount is Rs 49,500 (Rs 48,750 plus Rs 750).

Assuming that the investment fetches a steady return of 10% per annum and no charges are levied by the fund house, the investments would be worth Rs 64,886 and Rs 65,885 for case 1 and 2, respectively, at the end of a 3-year period. Hence the investor accepting a rebate would be 'richer' by approximately Rs 1,000 or would have an additional gain of 0.55% to show for.

Interestingly, if both the investors stay invested over a 5-year period, the difference in returns due to rebates declines; the difference which stood at 0.55% over three years drops sharply to 0.34% over five years.

Apart from circumventing the law, the investor accepting rebates could be taking on a significant risk of getting invested in the wrong avenues. This in turn might lead to non-achievement of his financial goals and objectives.

Here's a thought -- the distributor offering rebates actually parts with a part of his income. Ever wondered the objective for doing so? Does he do that to make good some deficiency in his ability to recommend the right investments or to cover up his poor service standards?

Conversely, investors have the option of dealing with an investment advisor/distributor whose USP is providing then right advice coupled with high service standards. Distributors of this variety 'compensate' investors by recommending appropriate schemes and ensuring that their client's objectives and goals are met.

In the illustration above, the individual investing Rs 50,000 earned an additional Rs 1,000 over a 3-year period. Wouldn't sacrificing the measly rebate be a small price to pay for being associated with such a distributor?

That's a question for investors to ponder over. Choose a distributor who offers you a rebate and in the process might expose your financial planning to risk (thanks to his incompetence); on the other hand you can select a distributor who delivers on the right parameters -- advice and service. Spare a thought on this the next time you decide to get invested.

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