Mutual Funds Should Do More

January 26, 2014

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:

 

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.

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