The trouble with mutual funds

At a glance

  • Equity mutual funds offer a convenient avenue to get professional management of your money to be deployed into stocks
  • Diversification by exposure to a large number of companies and liquidity are also key advantages of mutual funds
  • But the inherent disadvantages are expenses and investor behaviour in lock-step leading to large scale purchases and redemptions
  • For the investor, the huge number of fund options offer a problem not unlike having to pick the right stocks
  • In addition, the past variability in fund performance and unlikelihood of superior performance staying that way make choices difficult
  • Exchange-Traded Funds (ETFs) mitigate some of the disadvantages of Mutual Funds and are a viable investment vehicle for the calm investor

If you’re a busy professional who understands the importance of investing in the equity market for long-term wealth accumulation, the idea of investing in equity mutual funds makes a lot of sense. However, there are certain challenges specific to mutual funds that give the calm investor reason to pause.

The Basics

A mutual fund is a pool of money collected from many individuals so it can be invested by a professional money manager in a variety of assets, defined by the mandate of the fund. There are several kinds of mutual funds based on their area of focus (equities, debt, balanced (mix of both)), whether or not they allow investors to buy and sell all year around (open-ended vs closed-ended) and areas of specialization (sector-specific, thematic, the list is endless). Given our focus on mutual funds as an alternative to directly investing in equities, in this discussion, when we say mutual fund, we mean “open-ended equity funds”

The Fund Manager and her team use this money to buy shares. The manager could choose to sell some of those shares due to favourable price movement or because holders sell their units resulting in sales of the underlying shares. Subsequent market movements then reflect in the returns performance of the mutual fund much like they do for individual stocks.

Well-known pros

Professional management

Money managers are typically seasoned veterans in the capital markets with educational and professional expertise. Additionally, in contrast to the lay investor who must find time outside of his day job to analyze stocks, which in fact is the day job of fund management teams

 Diversification

A mutual fund could invest in anywhere upwards of 30 companies in varying proportions. Owning even one share of each of those companies would be out of reach for most retail investors. Since each unit of a mutual fund represents ownership of all the shares the fund has invested in, it offers investors a convenient way to diversify

Liquidity

As opposed to shares where a buyer and seller need to agree to a price, mutual fund units can be sold back to the fund which agrees to pay the last recorded unit value irrespective of whether other retail investors are willing to buy

The cons

Expenses crimp returns

It’s obvious there is a cost to having a professionally managed fund. The problem is that this number is sizable, the median for over 370 equity funds in India is 2.65% of assets under management. So the investor’s returns start at negative 2.65% which needs to recovered before any gains can be made. This number looks tiny in a year where markets advance by 30+% but looks unfairly large when markets languish or creep downwards

Success breeds failure

Funds that show excellent returns over the previous year see sudden inflow of money as investors pile into it, much like in a sought-after “growth” stock. The fund manager now has to find stocks that he doesn’t yet own or buy more of his existing stocks at higher prices thus reducing potential future return

Subject to Mr. Market’s whims

If you own a stock you think is fundamentally strong but loses value in a broad market sell-off, you have the option to wait it out and even buy more of the stock at more attractive valuations. A fund manager does not have that critical advantage since he has to respond to his investors’ actions. If they respond to doom and gloom predictions and redeem their units, the manager has to sell the holdings at a time when they are their most depressed to return the money. This impacts returns for even those unit holders who stay investedWhile the above pros and cons apply to every fund, an investor needs to consider another set of factors when considering mutual funds for investment

The investor’s pitfalls

Mutual Funds

Problem of plenty

A quick scan on valueresearchonline.com shows that there over 40 fund houses offering over  350 open-ended equity funds as of March 2014. Of these, 280 funds have been operational for at least five years. The investor looking to ease their burden of analyzing and picking the right stocks is now faced with the task of picking the right fund house and fund that will deliver the right returns

Variability in mutual fund returns

The importance of picking the right fund becomes even more apparent when considering the variability in returns of the best and worst performing funds in any given year. Chart shows the best, worst and median returns within the 74 funds that have been around for 10 years.

Future performance uncertain

Picking the “right” fund based on excellent past performance might seem logical but here again historical results are not encouraging.

If for example, in 2007, if you were looking for a fund to invest in and purely looked at historical performance, the SBI Contra fund would show up as one of the top performers. Comparing it against other funds that had been around for atleast five years would rank it in the top 5 for three of the five years. At the same time, in comparison SBI FMCG, would have shown distinctly ordinary performance from 2002 to 2007, but then outperforms and becomes one of the top performing funds overall over the last four years.

Chart compares annual performance between SBI Contra and SBI FMCG from 2002 to 2013.

Given that the objective of any investment policy should never be to “beat the market” but to make healthy gains over the long-term, mutual funds are a viable investment vehicle. The problem is with picking the right fund and being able to stick with it. Since the effort required seems to me to be comparable to researching stocks, I have not been the biggest fan of actively managed mutual funds.

 For the busy professional we referenced at the start of this post, a more cost-effective and less guess-work ridden exercise would be to invest in Exchange Traded Funds (ETFs). More about that in another post.

References (External links):

Mint 50 Best Funds (LiveMint)

Five bad ways to pick a mutual fund (Wall Street Journal)

How to choose a mutual fund (The Motley Fool)

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