Let us unravel the truth behind mutual fund investing inspired by the writings of Benjamin Graham in his book – The Intelligent Investor.
A purely American creation, the mutual fund was introduced in 1924 by a former salesman of aluminium pots and pans named Edward G. Leffler. Mutual funds are quite cheap, very convenient, generally diversified, professionally managed, and tightly regulated under some of the toughest provisions.
Mutual Funds are not perfect. They are almost perfect, and that word makes all the difference. Because of their imperfections, most funds underperform the market, overcharge their investors and suffer erratic swings in performance.
FinSharpe analysed data for different categories of mutual funds.
Most funds that topped the ranks in 2019 have come to the bottom in 2023
Category : Large Cap.
Total funds considered during analysis : 23
Category : Flexicap
Total funds considered during analysis : 19
Category : Large Mid Cap
Total funds considered during analysis : 19
Baring a few exceptions, the performance ranking of funds based on one- year returns fluctuates significantly.
Four Reasons For Fund Performance Fluctuation
Why don’t more winning funds stay winners?
Migrating managers: When a stock picker seems to have a Midas touch, everyone wants him/her – including rival fund companies.
Assets Elephantiasis: When a fund earns good returns, investors notice, often putting in more capital in a matter of a few months. That leaves the fund manager with few choices – all of them bad.
He/She can keep that money safe for a rainy day but get a low return on cash. He/She can invest in stocks the fund already owns, which may now be at a higher price and drive up price further. Or find new opportunities that he must have already stumbled upon before but chose not to.
Herding: Once a fund becomes successful and of a large size, its managers tend to become comparatively timid and imitative. The biggest funds of the same category have nearly the same stocks in their top holdings.
Expenses: Operating expenses and trading costs are often higher for these funds and these costs rarely fall with rising Assets Under Management (AUM).
While there are benefits of mutual fund investing, investors must consider several parameters while selecting a fund and not just past returns. Some parameters to look at are :
Sharpe Ratio
Downside Capture
Assets Under Management
Expense Ratio
Stock Overlap
Returns compared to Category
Performance Consistency
Since there is analysis involved while selecting a fund, what could be a possible solution for the passive investor?
Index Funds Or ETFs
This is a portfolio of stocks designed to mimic the composition and performance of the financial market index.
eg: NIFTYBEES mimics the Nifty 50 Index
Some benefits of Index investing are :
Simplicity
Lower costs
High diversification
Lower company specific risks
Lower volatility compared to active funds
As the Indian mutual fund industry breaches the Rs 50 lakh crore mark, investors should be more aware of the pros and cons of mutual fund investing.
The Association of Registered Investment Advisors (ARIA) has a list of various SEBI Registered Investment Advisors who could assist investors with the right approach towards asset allocation and fund selection.
Rohan Borawake is Co-Founder & CEO, Sabir Jana is Co-Founder and Head of Quantitative Research, at FinSharpe Investment Advisors. Views are personal, and do not represent the stand of this publication.
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