Mutual Funds
Difficulties of managing a mutual fund

In the desire to beat benchmarks, many mutual fund schemes end up adopting strategies which do not work well in the long run

Mutual funds, as a popular investment vehicle, are often projected as panacea for investment requirements of individual investors. Since individual investors lack skills to invest directly in the market and have limited ability to manage vagaries of market movements, mutual funds become natural investment option for investors opting to invest in equities and some other complex asset classes. It is expected that mutual funds are professionally managed, reduce risks and offer returns which are should not just be able to beat inflation but be good enough to provide handsome return. It is because of these reasons that mutual funds are scrutinised extensively for their performance. Running a mutual fund is not an easy job. Over the last six years, especially post-2008 crisis, mutual funds have undergone microscopic examination and have experienced mass exodus of retail investors.
 

So what is it that makes the job of a mutual fund difficult and where does the challenge emanate from? There is more than one factor which poses challenges for the successful existence of a mutual fund. Here is an analysis of some of these factors:
 

Too many mutual fund schemes chasing too few quality stocks
 

As per AMFI (Association of Mutual Funds of India) data for the month of November 2013, there are 293 schemes of equity mutual funds in India. There is no doubt that these schemes cater to different requirements. While some funds are sector funds, some are large caps and some funds focused on mid-cap stocks. But the most relevant question here is: “do we have too many good companies in India?” In other words, do we even have 293 companies listed on stock exchanges which can be classified as investment worthy? The answer would be a firm NO. It is true that one mutual fund scheme requires only 20 to 30 companies for investment but with so many schemes of one single mutual fund around, it becomes challenging for a mutual fund managers to invest differently. Many mutual funds have ended up investing in such companies which have failed miserably and have given below average return. This has adversely impacted performance of mutual funds.
 

Inability to create product differentiation
 

For the reasons best known to a mutual fund house, many new schemes are created even when existing schemes are difficult to manage. More schemes mean challenges of product differentiation. It is often difficult to differentiate two large cap funds. The need for differentiation results into wrong stock selection or in some cases concentration of fund portfolio into selected stocks only. Nifty and Sensex stocks dominate most of the large cap funds with weightage of stocks being the lone differentiator. For an investor also, it becomes difficult to select one mutual fund from many similar types, unless a particular scheme has a past which shows that the scheme has done well.
 

Pressure to outperform benchmark indices
 

Recently one leading mutual fund came out with an advertisement on the first page of The Economic Times, claiming that all its equity schemes have beaten the benchmark index in a five and and 10 year periods. This shows how important it is for a mutual fund scheme to beat the benchmark index. Since comparison with the benchmark index is often seen as the barometer of the performance of the fund, mutual fund schemes put all their energy into beating an index. It is pertinent to note that while an index like S&P BSE Sensex is a passive entity, a fund manager gets all the opportunity to churn portfolios to beat the benchmark index. Still, many schemes fail to beat the benchmark index. In the desire to beat the benchmark index, many schemes end up adopting strategies which do not work well in the long run.
 

An investor generally feels that a mutual fund scheme will take care of his financial requirements of wealth creation. But in the current scenario, selecting a good mutual fund scheme has become as challenging as selecting a good stock. Proliferation of multiple schemes of mutual funds has created a dilemma for investors. While investment in schemes of a mutual fund is a good idea for sustainable wealth creation, selecting a good mutual fund has become the biggest challenge for an ordinary investor. Needless to say, this comes from the difficulties that mutual funds have created for themselves.
 

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)

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COMMENTS

Dayananda Kamath k

3 years ago

one of the main reason for faiure of mutual funds is they launch new funds when market is at the peak naturally their nav will come down when there is correction from peak and people start redemption which further erodes value as market fall due to this selling. and surprisingly if they bring new schemes when market is down it will not be subscribed. quick rich mentality of indian investors is the reason for failure of this great avenue for investment. and regulators are also reactive than proactive in india.

Abhijit Gosavi

3 years ago

Hate to say this, but the fees charged by mutual fund managers are unjustifiably high! Fama may not have been perfectly right, but investing in index funds (Vanguard in the US; don't know about Indian equivalent) is a better option because of the lack of (or lower) fees. Those managers who try to sell you "downside risk," "alpha" and "beta" etc --- encouraging you to be risky --- are just lining their own pockets. There is ZERO science underlying those impressive sounding formulas.

Plus, one has to remember that because of the effect of compounding, one loses lots of money over a span of 20-30 years because of the fees. Just my two paise :)

Bhavesh Chauhan

3 years ago

The Mutual funds churn their portfolio a lot to generate the so called "alpha". There should be some sort of restriction on quantum of churning.
They should be encouraged to report five year period returns rather than compare annually against the benchmarks.

Also reports of front running by Fund managers are not uncommon - which have not been strictly dealt with by the regulators - no wonder customers have also lost the confidence on them.

Ideally, a fund should not charge fees as a % of AUM, but it should be only on profits earned by the customers. The existence of entry and exit lot is mere looting of the customers although it is necessary to bear the costs of running a fund.

REPLY

Abhijit Gosavi

In Reply to Bhavesh Chauhan 3 years ago

Can't agree with you more, my friend. Those fees are astronomical, and you are perhaps even better with a savings deposit with a bank in many cases. In India, the banks pay the kind of interest unheard of in the West (because of the inflation of course).

But can the regulators really do anything about that? Customers should not be going to these managers in the first place. Unfortunately, so many people don't realize that until after they've lost tons of money.

Santosh Kanekar

3 years ago

Investment choices can never be simple, Mutual Funds cannot be an exception.

It is easy to point fingers at mutual funds but where are the options to build wealth?

There is a moneylife article which shows that Passive funds in India have not done as well as in US. In US, Passive Funds beat Active over the long run.

At the end of the day, all so called investment is subject to risk because outside of FDs everything is speculation.

Anil Singh

3 years ago

The advertisement of said claim was totally misleading. It said that all its equity schemes have beaten the benchmark index in a five and 10 year periods. But not in returns or NAV, only in AUM (asset under management). AUM does not mean anything for investors. It only denotes the MF has more money from investors and earned more fees.

Sandeep Consul

3 years ago

Are Mutual Funds taking Investors for a ride?

Mutual Fund investors these days are a disgruntled lot. Having been sucked in to Equity Funds with past performance records and some aggressive selling they now stand at a crossroad. Here are some of the reasons which led to the dismal performance of Equity Funds over last 5 years.

BENCHMARKING

“I am not concerned with absolute returns of my schemes, my job is to outperform the benchmark” says a fund manager in a leading financial daily of the country. Conversations with many CIO’s, Fund Managers over last 15 years have revealed that the fund manager’s remuneration is linked to their performance against the benchmark and the peer group. This is a major source of complacency and callousness among the fund manager community. This is also the biggest difference between the objective of an investor who is interested in absolute returns, and the fund manager whose primary motive is to protect his job by giving returns close to the benchmark. So if Nifty is down 25% in a year and the fund is down 22% the fund manager gets to keep his job and bonus but the poor investor has lost 22% of his investment (who may have been in the wrong place to begin with because of lack of emphasis on investor education, scrupulous agents, aggressive marketing tactics by Mutual funds- latest example- login days – various incentives to distributors based on number of SIP applications they procure on that day. AMC’s have a very good idea as to what happens to most of these SIPs, but at least it saves the day (quarterly/yearly target) for them, like NFOs used to do few years back.)

As Jeremy Grantham points out “The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing.
Now let us see how this benchmarking affects performance:

Typical benchmarks that are used in India are Nifty, Sensex, and BSE 100 etc. Now let us understand the composition of benchmark- the companies in the benchmarks are the biggest companies by Market Capitalization from different sectors (with different weights based on free float etc). These are not necessarily the best companies of the country to invest in as far as quality of management, efficiency, financial performance and many other parameters are concerned. Some of the names appear like the ultimate giants based on sheer Turnover figure or Market Capitalization (thanks to the bloated equity, government patronage etc) but they do not inspire any confidence at all.

Quite often when a particular sector becomes flavour of the season etc. (remember the Tech boom and the Infrastructure boom), the stock price of the leaders of that sector zooms to stratospheric heights hence market cap goes up, they get included in the Indexes (these are the benchmarks for the Mutual Funds). When the sector goes bust, prices many times fall to less than 5% of their peak values and ultimately lead to exit of these companies from benchmarks….. remember Satyam, Zee, Unitech - this may be fine for a benchmark but when a scheme replicating (well almost) the benchmark does the same thing they are just destroying investors wealth - its literally buy high and sell low -which goes against basics of investing. It’s not unusual to see a company getting included in the benchmark when its stock price is in four digits and getting excluded when the price is in double digits. .. And the fund managers take great pride in beating such benchmarks. So if a stock gets included in benchmark at 2000 and is kicked out at 50 and the fund manager who mimics the benchmark or even beat it slightly ( having bought at 1800 and sold at 70) he is not doing great justice with investors money.

During last 5 years Sensex has gone up from 14,600 to 21,000 (Jan 08) came down to 8,000 (Oct 08 & March 09) went up again to 21,000 in Nov 10 and is above 16,000 now. So last 5 years had two up moves and two down moves. Fund management teams had enough time (5 years) and enough volatility in the market (with their education, experience and professional expertise of Active Management & Superior Stock Selection Skills) to generate decent absolute returns during this period.

BSE Sensex has delivered an annualized return of 2.16% over last 5 years (ending 31st May 2007) excluding dividends. It’s well known that equity is a High Risk-High Return Investment Option on a simple Risk-Return chart. Over last 5 years only about 12% schemes have been able to give over 8% annualized return during the same period (8% is the rate on RBI Bond available to investors). For this, a simple point to point return calculation was done on Value Research for the said period for all equity schemes (excluding sector funds). Even if you consider that returns from equity are tax free and you consider the middle tax slab of 20%, the returns from RBI Bond will be slightly below 6.5%. Only 22% schemes were able to beat this return. So much for taking higher risk. And next time, the 20% or so schemes outperforming, may be quite different from the current outperformers (who said that the Mutual Fund scheme selection is any easier than stock selection). Yes, there can be criticism about taking arbitrary dates, doing investment on a single date instead of SIP etc. The hype over SIP and selling it as a panacea for all ills will be taken up in detail later. Deepak Shenoy mentions in his post on 25th May 2012 that “Sensex 5 year rolling returns is at 2.21%, including dividends its 4.55% and return on 5 year SIP investing every month in Sensex is at 2.3%.”

There was a study in Economic Times (April 2, 2012) also that Bank FDs beat equities in 20 years holding period. Yes, there were some articles countering that with the argument that effect of taxation is not incorporated in the analysis, if we change the start date or the end date results will be slightly in favour of equities, the study takes in to account only one time investment and not SIP etc.

Anyways, this article is not about virtues of Fixed Income instruments vs. Equities. It’s about lack of performance or under utilization of the potential of fund managers because of being too fixated on the Benchmarks. Whenever you present these facts to fund managers they immediately get defensive and start talking about (very) long term Sensex returns… if you take a verrrrry long period, say Sensex returns from 1980 when Sensex was 100 J ( that was pre-liberalization era when India was still an undiscovered story and the markets were not open to foreign investors), or that last 5 years have been different. What makes them feel that next 5 years will not be tough? At global level, the leaders don’t have the political will to admit that there is a problem and kicking the can down the road seems to be the best strategy to get re-elected. At domestic level, every one in the country except fund managers know that there is an absolute policy paralysis.
According to a report in business standard (03 May 2012) several mutual funds are found comparing their performance against the benchmark indices and then deciding whether or not they have outperformed. While doing so, it has been found that MFs show their performance where dividends are reinvested but the benchmark indices against which they are comparing returns are not showing total (with dividend) returns. This leads to unfair comparison.
According to the same report a study by Morgan Stanley Research show that dividends have accounted for a little over a fifth of the total return from the BSE Sensex over the past decade. The Sensex has been up 390 per cent over the decade. Sensex dividends have compounded annually at a 40 per cent rate. Hence, the total Sensex returns are about 480 per cent or 23 per cent higher than the index return. Put another way, if the Sensex dividends were reinvested, the Sensex would be at 21,200 instead of its current level of 17,300. For Indian residents, dividends are tax-free and, hence, their contribution to post-tax returns is even higher.
Debashish Basu pointed out in Moneylife (October 18, 2011) that “even the best funds tie up the bulk of their money to the heavyweight stocks of the benchmark, making it hard for investors to separate market performance from stock-picking skill. The popular perception of fund management is that investment experts pick stocks that either reasonably valued or have strong earnings growth ahead of them or both. Some also believe that fund managers are experts at buying and selling. While all this is sometimes true, the fact is that most fund managers are happy to pick the heavyweights of the underlying benchmark indices and sit tight. A total of 57 of the 100 largest equity schemes have Reliance Industries as a top 10 holding. Not because RIL has been a great stock, but because it is a Sensex and Nifty heavyweight. Funds don’t want to stray too far away from the benchmarks! They simply preferred to inflict massive losses on their investors and stay with this heavyweight. If dozens of top funds all keep holding a stock that has fallen by 40% or more from the peak and has continuously underperformed the index massively, it can only mean deep collective wisdom across all fund houses about the future returns from the stock. Or, it could mean active investing of the worst kind, because it really amounts to closet passive investing.He adds that “In 2007, when I was interviewing a low-profile but reasonably good fund manager, he gave me a rare peek into the core investing process followed by fund houses. “When the money comes into the fund, we quickly allocate the bulk of it according to the stocks in the benchmark we have chosen.” He added with a smile, "We don’t want our performance to lag the benchmark.” Therefore, investing a substantial amount of money in index heavyweights is part of a “strategy”—even if this means that these index heavyweights may not be the best of picks at that particular time. This is exactly why Reliance, which has been grossly underperforming for over two years since June 2009, is a top 10 holding of more than 100 fund schemes among a total of 230-odd equity schemes. This is simply because mutual funds are primarily managed with an objective to “stay as close as possible to the benchmark.” As a mutual fund salesperson told me once: losing money is not a big issue in the mutual fund industry. But what is really a big issue is grossly underperforming the benchmark.” One way not to underperform the benchmark is to be substantially invested in benchmark heavyweights. This “strategy” has cost fund investors dearly.”
The fund management industry has very smartly hyped up the “benchmark concept” so that no body questions their perceived expertise/superiority in market timing/stock selection skills. It’s like a five hundred pound gorilla making the rule that as long as I continue beating a five year old I will continue to rake in the mullah. No wonder the fund managers have become highly complacent.
Every once in a while Fund managers come out with reports with lots of statistics/charts/graphs trying to prove that it’s a good time to buy because based on XYZ parameters markets are undervalued etc. like “why 17000 this time is different”. In last 5 year’s Sensex has hit 21,000 twice, but none of these fund managers came out with any report to move out/book profit/be cautious (when on the very same parameters markets were expensive) in any such data filled write up or even in the outlook section of their monthly factsheets. So what’s the difference between a fund manager and a retail investor (we haven’t forgotten the fiasco of tech bubble bust when in 2000 one of the largest schemes in the country had 55% exposure to top 6 stocks and the NAV dropped by 80% during the next few months, or during the fall) If the fund manager thinks that it is their right to tell the investing community “When to Buy” (based on their expertise) then it’s their duty also to tell “When to sell”.

Right from morning till late night fund managers keep giving us this “undiscovered” sensational funda that “Markets will be volatile this week/month/year” J or …….having said that India is a great long term story, India is in a long term structural bull market”. At the beginning of the year CIO of one of the largest fund house in this country made the startling revelation that “Markets will be volatile in 2012”. I can imagine he will make the same Rocket Science prediction every year. They all speak the same language, same slangs and have similar view on the direction of equity markets as well as interest rates, for the reasons mentioned earlier. A fund house with a “Value” and a “Growth Scheme had 15 common holdings out of top 20 stocks of both the schemes. On top of that, they had the guts to justify that all these stocks are Value as well as Growth stocks. I wondered if they will launch a scheme called “Value and Growth” Fund. Another fund manager gave a very strange justification as to why they use Reliance instead of Cash as it is a liquid stock, without realizing that Reliance has underperformed even cash for last few years.

The classic example of the expertise of the fund management and their team of analysts is of “Satyam Computers”. Many top fund houses of the country were totally caught off guard when Mr Raju dropped the bomb in January 2009 that Satyam’ reported Profits and Assets were bloated many times over. So what can kind of analysis was being done in these houses. No primary research? Only cut and paste operation based on figures reported by the company and research reports of various investment houses. Some fund managers had bought (or added to their holding) the stock only a month back when the Stock had a sharp fall after Satyam’s board meeting in which the board decided to diversify in to unrelated area like Realty and that also in the company of the promoter’s children. One fund manager came out with a detailed justification of why he thought it was a value buy after the fall (inspite of the fact that the integrity of the management had gone for a toss with the above decision.) When the Regional/Branch teams have calls with fund managers they can not muster the courage to ask the right questions and when they do so, they are bombarded with, technical jargon by the high flying fund manager with no chance of counter argument or sometimes even curt statements like “if our performance was good we would not need you to sell our schemes”. When the concall is with the distributors, the fund managers give very elusive reply to any uncomfortable question and quickly move on to the next question. Most of the time the sales team end up facing the distributors and investors, and giving quite illogical/absurd justifications for various stunts by the fund management team. As a national sales Head of a Fund House told very candidly that the fund mangement team is our biggest expense and the worst nightmare. We are the ones who face the music from distributors and investors all over the country for their poor performance.

Majority of the fund managers continue to flourish with job security and bonuses because they beat their benchmark and show their superiority J while millions of equity investors continue to suffer with the unsatisfactory performance of the schemes.

To be continued…

REPLY

Francis Xavier R

In Reply to Sandeep Consul 3 years ago

Waiting for yr next part, sandeepji.

Ramesh Poapt

3 years ago

AMCs/Fund Managers always blame investors for not investing in MF orredeeming MF instead of hiding their mistakes/under performance.
Reputed schemes have underperformed the benchmark for quite a long time.Investors are not nonsense as it is claimed loudly.

Vaibhav Dhoka

3 years ago

Nothing is trustworthy in India nor Mutual fund or PMS.The best is one should study and bye on his own knowledge.

REPLY

Suiketu Shah

In Reply to Vaibhav Dhoka 3 years ago

100% correct.If one wants to invest MF,best is to follow moneylife's mutual fund stock picks which are far better than any benchmark or any claims on front page of eco times by MF company.

Nilesh KAMERKAR

3 years ago

Investing in equity funds is pretty simple. It becomes complicated when unnecessary comparisons attract more attention than the objective of building a decent nest egg.

pravsemilo

3 years ago

Dear Mr. Vivek,

The advertisement that you mention was a very clever one. It cleverly mentioned the % of AAUM that had beaten the benchmark instead of the number of the funds that should have been mentioned. More than 75% of the fund house's AUM is concentrated in its 3 funds and it is these three funds which are currently doing good.

The fund house went on to claim that 87% of its funds had beaten the benchmark over five year period and 100% over the 7 years and 10 years.

raj

3 years ago

good article

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