This article was published in The March 2014 issue of the Global Analyst
It is not my intention to criticize mutual funds for I was also an avid investor till recently. However, the normal claims about virtues of mutual fund investing amuses me sometimes. Recently I read an online article published in Times of India with a fancy title “Why should you invest in mutual funds?” Like a lay reader, I started browsing through the contents till I realized that if not all, many of the claims can be easily rubbished. Here is a run-down on the claims of the virtues of mutual fund investing and the truth explained alongside:
It is not my intention to criticize mutual funds for I was also an avid investor till recently. However, the normal claims about virtues of mutual fund investing amuses me sometimes. Recently I read an online article published in Times of India with a fancy title “Why should you invest in mutual funds?” Like a lay reader, I started browsing through the contents till I realized that if not all, many of the claims can be easily rubbished. Here is a run-down on the claims of the virtues of mutual fund investing and the truth explained alongside:
1. Beat
Inflation:
The
MYTH: “Mutual Funds help investors generate better inflation-adjusted returns,
without spending a lot of time and energy on it”.
The
TRUTH: This is true only if the mandate of the fund is to beat the inflation
i.e, TIPS like product (Treasury inflation protected securities). The RBI has
just introduced a un investor friendly product and is still dusting the finer
elements. However, I suspect the claim was made more in the generic context of
equity mutual funds. Equities as an asset class beat inflation not because it
is structured as a mutual fund, but because of the inherent ability of the
asset class to perform better than the inflation. Even if I buy some 10 good stocks
and sleep on it for 20 years, my investment should beat inflation without the
hassle of being structured as a mutual fund.
2. Expert
Managers:
The
MYTH: “Backed by a dedicated research team, investors are provided with the
services of an experienced fund manager who handles the financial decisions
based on the performance and prospects available in the market to achieve the
objectives of the mutual fund scheme.”
The
TRUTH: Academic research has proven time and again that fund managers as a
group do not beat the market. Also, those fund managers that beat the market do
not do it consistently. In other words, if you invest in a fund that has
performed well because you got charmed by the fund manager, in all likelihood,
he will trail the performance since there is no consistency in the performance.
In the whole of the investment history, there is only handful of examples where
fund managers performed consistently and even here they have attributed that
more to luck than skill. Obviously there will be some fund managers that will
do better than others and the market but there is no scientific way of knowing
that in advance.
3. Convenience:
The
MYTH: “Mutual funds are an ideal investment option when you are looking at
convenience and timesaving opportunity. With low investment amount
alternatives, the ability to buy or sell them on any business day and a
multitude of choices based on an individual's goal and investment need,
investors are free to pursue their course of life while their investments earn
for them”.
The
TRUTH: If technology helps mutual funds to offer convenience, the same
technology offers investors the option to directly buy and sell financial
instruments including post office savings. Opening a trading account with any
reputed institution is just a matter of signing in 37 places, and beyond this
hassle everything else is just a click of button. You can buy 1 share of
Infosys and sell 1 share of Hindustan Lever and for that level of volume all
else including electronic demat, service tax, sms alert, etc is done by the
technology.
4. Low
Cost:
The
MYTH: “Probably the biggest advantage for any investor is the low cost of
investment that mutual funds offer, as compared to investing directly in
capital markets. The benefit of scale in brokerage and fees translates to lower
costs for investors.”.
The
TRUTH: By definition mutual funds have to add extra cost to a transaction due
to management fee, custody, etc. While they can bargain for lower fees due to
scale, since they are normally applied as a % to total assets, there is no
economies of scale. Also mutual funds get research from brokers apparently free
of cost and in return for this favour, they are encouraged to trade more
(technically referred to as portfolio turnover). The tendency to trade higher
due to this in fact increase the cost. Left to himself or herself, the investor
can buy when needed and sell when due only sporadically in order to achieve the
same result at a far lower cost.
5. Diversification:
The
MYTH: “Going by the adage, 'Do
not put all your eggs in one basket', mutual funds help mitigate
risks to a large extent by distributing your investment across a diverse range
of assets”
The
TRUTH: Mutual funds certainly don’t diversify more than the index to which they
are benchmarked. It is due to this reason, they sometimes over diversify! Most
of the index have a skewed distribution with the top 10 or 20 stocks accounting
for 70 to 80% of the total with the remaining 100 or 200 stocks accounting for
the balance 30% or 20%. A typical mutual fund portfolio will have its top
holding a share of say 5 to 8% while the last stock in the portfolio will have
a share of say 0.2% or 0.1%. While technically the portfolio has more than 40
to 50 stocks (substantiating the claim of diversification), the puny allocation
to most of the stocks do not technically contribute anything meaningful to the
performance of the overall portfolio. Assuming the last stock with 0.2% weight
increases dramatically in value say by 25% in a particular month, its impact on
the overall portfolio is only 0.05%, hardly moving the needle! Also, academic
research says that you need only 10-15 stocks to meaningfully diversify beyond
which the diversification benefit tends to reduce exponentially.
6. Liquidity:
The
MYTH: “Investors have the advantage of getting their money back promptly, in
case of open-ended schemes based on the Net Asset Value (NAV) at that time. In
case your investment is close-ended, it can be traded in the stock exchange, as
offered by some schemes”
The
TRUTH: While it is true that liquidity is provided by mutual funds, the same
liquidity is available even for direct investments and hence mutual funds do
not provide anything additional in value. The current regulations requiring pay
out in T+1 and T+2 ensures that one receives liquidity well on time.
7. Higher
Return Potential:
The
MYTH: “Based on medium or long-term investment, mutual funds have the potential
to generate a higher return, as you can invest on a diverse range of sectors
and industries”
The
TRUTH: The higher return potential does not accrue because it is structured as
a mutual fund. The higher return potential probably accrues because of longer
time frame and stock selection capabilities in case of equities. As said
earlier, if we select 10 good stocks and invest in them for say 5 or 10 years,
it should provide higher return potential regardless of the fact that it is not
structured as a mutual fund.
8. Safety
and Transparency:
The
MYTH: “Fund managers provide regular information about the current value of the
investment, along with their strategy and outlook, to give a clear picture of
how your investments are doing. Moreover, since every mutual fund is regulated
by SEBI, you can be assured that your investments are managed in a disciplined
and regulated manner and are in safe hands”
The
TRUTH: Stocks purchased directly and lying the demat account is as safe as
mutual fund investment. There is no added safety because it is a mutual fund structure.
In terms of transparency, thanks to technology the trading platform provide
dissection of the portfolio without any additional cost.
9. Product
Variety:
The
MYTH: “Mutual funds offer variety of products across asset classes like equity,
bonds, money market, real estate, etc”
The
TRUTH: While it is true that they offer variety, the problem is investors are
perplexed by the swathe of offerings and choices. In fact, the process of
choosing among funds today is far more complex than choosing stocks. In other
words, investors who avoid picking stocks thinking that they are too complex
actually play a far more complex game of choosing funds”
Apart
from these limitations, mutual fund manager also suffer other issues connected
with liquidity and fund size. Even well regarded blue chip companies can suffer
from poor liquidity leading to higher cost. Mutual funds should suffer this
problem especially in mid and small cap stocks. Given their ticket size, their
requirement will always exceed what the market trades on a typical day. Also,
if the fund has grown big, it will have a tendency to hug the market in order
to avoid the risk of underperformance. In other words, the propensity to take
risk is reduced while the managers are paid management fee to take risk!
In
summary, a mutual fund is a convenient structure for the fund house that earns
good management fees. It is lucrative for the fund managers who earn fat
salaries, sexy bonuses and television attention. It is productive for
regulators as it keeps them busy. It feeds a host of other related industries
like broking, custody, HR, etc. After all this drama, it is still anybody’s
guess as to which fund will outperform the benchmark and the peers. As a lay
investor, you are better off investing in a Exchange Traded Fund (ETF) that
enjoys the lowest cost. If you are slightly informed, you may want to try
enhanced index strategies. If you are hands on in the market, you are better
off identifying and investing directly in some 10 good stocks and sticking with
it.
Happy
investing!
PS: The author thanks Rajesh Dheenadhayalan for his assistance on this research.
PS: The author thanks Rajesh Dheenadhayalan for his assistance on this research.
