10 Facts about Mutual Funds that You Must Know
A common man believes that an investment guru, research analyst, market strategist or, for that matter, a mutual fund (MF) manager is invincible. He has a very good educational background, vast experience, an army of personnel to assist him and all the tools required to manage people’s wealth in the most effective manner generating above-average market-beating returns. But is it really true? Is the fund manager really able to beat the markets, year after year? Is the fund manager’s performance better than the common investor’s? Is the fund manager invincible? 
 
Probably not. If that were the case, why do the majority of the actively managed funds underperform the passively constructed stock indices, over long periods of time, globally? So, let us understand that, in spite of all the added advantages described above, there are problems with MFs which actually stop them from beating a smart investor on the street or the index. 
 
Fact 1: Humanly, Outperformance Not Possible: Fund managers suffer from trying to consistently and continuously outperform the markets which is humanly not possible for the whole group. The fact of the matter is that most people have no reason whatsoever to believe that they can pick winning stocks or time the markets. Their success at it would be like throwing darts at the financial pages. 
 
I would like to quote Dr William Bernstein, a neurologist-turned-investment expert who has said that “there are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know where the market is headed. {subscription_div} Then, again, there is a third type of investor—the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know where the market is headed.” 
 
Nothing explains more succinctly the real world of professional investing and stock-picking. Merton Miller, Nobel Laureate and professor of economics at University of Chicago, commented that “if there are 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful, but they’re really not.” 
 
I would also like to quote from Stocks, Bonds, Bills and Inflation that “we all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it.” Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices! That’s why building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic. 
 
Fact 2: Success Linked to ‘AUM’ and Not ‘Returns’: This is a sad reality of the fund management industry. There is no strict alignment in the interest of the fund manager and the investor. Return is the prime objective of the investor while garnering larger assets under management (AUMs) is the prime objective of the fund manager. For the investor, an MF scheme earns him money from his investment while, for the fund manager, earnings are linked to the AUMs he manages. Yes, of course, if a scheme performs well, it would be able to garner more assets and, thus, earn more return for the fund manager. However, notwithstanding this, the fact is that, in their quest of garnering more assets, MF schemes end up with dubious practices, such as pushing more schemes in a bull market or wrong kinds of products  to take advantage of savers’ lack of knowledge.
 
Fact 3: Launching NFOs: Today, with hundreds of existing schemes, is there really a need for a new scheme for the investor? Is it really that the fund manager is able to offer something new through a new fund offering (NFO). Take the example of equity schemes. Today, a plethora of funds is available—large-cap, mid-cap, small-cap, multi-cap, diversified, sector schemes, theme schemes, asset allocation schemes, growth-oriented schemes, value-oriented schemes and many more. However, there is investor fatigue with the existing schemes as their performance is not up to the mark. 
 
It is difficult for MF distributors to continuously market the same old scheme. However, the fund house has to somehow garner new funds because its return is linked to AUMs. The fund distributor has to sell schemes because commissions and fees are dependent on the quantum of schemes sold. So what is the solution out of this deadlock? Simple. Take an old product, give it a new packaging, use difficult, yet impressive, financial jargon to lure the common investor and then aggressively sell it through the loyal MF distributors. 
 
Fact 4: Cannot Practise What They Preach: A fund manager will educate an investor to be patient with equities as they constitute ownership of a business which creates wealth over the long term. But are they themselves able to actually follow what they preach? May be not always. This is because the net asset value (NAV) of the scheme is declared on a daily basis and their performance is measured on a weekly, monthly or quarterly basis. If the fund manager were to follow his brain and do the right investments, his heart would bleed as he loses AUMs and, probably, his job. 
 
 
Fact 5: Advocate Market Timing Funds: Fund managers’ advice is that we should never try to time the markets. Theories like superior returns from stocks are generated not by timing the market but by ‘time in’ the market are propagated. But do these erudite fund managers themselves follow such principles? Not always. If they believed that market cannot be timed, why do they launch ‘market-timing schemes?’ Why do they churn their portfolio? The turnover ratio of some schemes is as high as 90%, meaning the entire portfolio is churned fully within a year. They create products like dynamic asset allocation schemes, low P/E schemes, etc. Kindly note that historically we have seen that almost 90% of portfolio variability is due to asset allocation while only 10% of the variability in portfolio performance is due to market timing and stock selection. The only thing in our control is asset allocation and the good news is that 90% of portfolio variability is due to asset allocation. Therefore, instead of promoting asset allocation for long-term wealth creation, many a times, schemes promote market-timing strategies.
 
Fact 6: Mis-selling of Income Schemes: Income schemes are nothing but interest-yielding debt products. But when someone deducts high fees from interest rate, what happens? A substantial fall in returns. That is exactly what happens with income schemes which are loaded with high fund management expenses. Investments in income schemes should, ideally, be done when interest rates are high because of two factors. Firstly, the inherent yield of the income scheme would be high which will ensure high accrual income. Secondly, if interest rates are currently high, other things remaining constant, there is more likelihood of their going down in the future—which leads to capital gains. 
 
However, unfortunately income schemes are not marketed when interest rates are high or are moving up. In fact, income schemes are widely promoted when interest rates have already moved down. The reason is very simple—when interest rates have already moved down in the near past, the past return from income schemes would be super normal. This high return of the past is then projected as the likely future performance of the scheme and sold along with the notion of ‘safety of capital’. 
 
And, mind you, the returns shown are ‘annualised returns’. I fail to understand how someone can annualise the return of a market-related product; it can be done only in the case of an accrual product. For example, if, say, the stock index goes up by 2% in one day, by any stretch of imagination, can someone just annualise it and say that the annual expected return on it would be 730%? Certainly not. But this is done and is an accepted norm for marketing income schemes to the innocent unsuspecting investor. Hence, investing in income or gilt schemes is nothing but paying heavily for buying an interest-paying security and then hoping to earn capital gains on it! 
 
Fact 7: Mis-management of Income Schemes: A fund manager hates it when his scheme underperforms. And the fund manager would certainly not like when there is a negative return on a debt product like an income scheme. Hence, during a rising interest rate environment, the fund manager would just reduce the maturity of the scheme and start managing an income scheme like a short-term plan. But, that was not the objective of the scheme. It was the view of the investor to put money in an income fund. When the investor wants to take interest rate risk and entrusts his money to the fund manager, who is he to take the call on behalf of the investor and move the goalposts?
 
Fact 8: Promoting Relative Performance: A scheme is marketed on the basis of relative, and not absolute, performance. What does it mean? Simply put, it means that if a fund manager loses 5% while the market loses 10%, the fund manager has done an excellent job. But, does this serve the purpose of the investor? Is the investor putting his money for getting positive returns or for getting lower negative returns! Of course, for getting positive returns. But then the fund manager’s performance is measured against a so-called ‘benchmark’ and if he beats the benchmark (which includes generating a lower negative return), he becomes a ‘star fund manager’ and is able to garner huge funds because, finally, the scheme and adviser’s income is related to the AUM and not its performance. In this AUM game, the investor is a sad loser. 
 
Fact 9: Taking Unwarranted Risk in Liquid Schemes: A liquid scheme may have negligible interest rate risk, since it runs a very short maturity but it certainly has credit risk as it primarily invests in corporate papers. And, mind you, for getting 5 to 10 basis points of higher return, often, a scheme takes unnecessary and avoidable risk of investing in not the best quality of papers.
 
Fact 10: Eternally Bullish: Yes, whether it is life or money, we have to be bullish or optimistic and it’s a very good quality but, in the investment world, we also have to be realistic. There are times when the underlying conditions like economic growth, inflation, interest rates, currency movements, etc, are positive while, at other times, they are not. A fund manager is supposed to give a true picture of the underlying economic and business scenario to allow the investor to take an informed decision. Why the fund manager suffers from this ‘ever bullish’ syndrome is very simple. A fund manager’s return is based on the AUM and his job is to attract maximum amount of money; if he himself is not bullish, how would a common investor be bullish and invest in his scheme? Hence, a fund manager has to be ‘eternally bullish’.
 
To conclude, we have seen the many issues a mutual fund scheme suffers from. However, are we to completely blame them for these? Probably not. In our quest for getting the best returns on our money, we force the fund managers to take unwarranted risk. Having said this, fund managers also have to assume more responsibility and take utmost care while managing funds. Finally, they are not just dealing with other people’s money but also trust. Money lost may be earned back, but trust lost might never be. 
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    COMMENTS

    BIKASH KUMAR VERMA

    2 years ago

    A common invester has only two things in his control , Money and Timing ,therefor a good finance adviser should not undermine the timing factor while soliciting his investor .

    KALPATHY KRISHNAMURTHY

    3 years ago

    I agree with Ramesh... the peice confuses .. I can distinctly see the Author does not want to stick out his position ...but then that’s hardly helpful... Are u suggesting stay away from MFs .?

    Ramesh

    3 years ago

    I felt that the aforeshown submission is found very lengthy,which put me in to confusion for submission of the comments. Request to provide the facts of the mutual funds in brief.It is of course very necessary to understand the same.

    Ralph Rau

    3 years ago

    "Asset managers should pay investors to run their portfolios and provide performance guarantees instead of earning fees regardless of the returns delivered to their clients, according to Mercer, the consultancy owned by Marsh & McLennan....


    Under Mercer’s proposal, active fund managers would retain any additional gains they made from stockpicking only after they had delivered a guaranteed return plus a fixed annual fee that had been agreed with clients. But any shortfall in performance would have to be paid by active managers out of their own pockets to ensure that they hold real “skin in the game” beside their clients’ money. “If asset managers really believe that they can generate alpha [market beating returns], this new approach should provide them with a strong incentive to reorganise their business models,” said Divyesh Hindocha, a partner with Mercer."

    https://www.ft.com/content/05b4f042-17e4-11e8-9376-4a6390addb44

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