Mutual Fund investing myths debunked!!   May 06, 2011

Mutual funds are an effective engine to route your investments in the equity markets. They offer several advantages over direct stock picking viz., diversification, professional management, light on wallet, economies of scale, liquidity, etc. But even after knowing the importance of investing in mutual funds, very often, we see that mutual fund investors are surrounded by myths based on widely held, yet incorrect beliefs and also based on flawed information. Both these kinds of myths can consequently lead investors to make incorrect investment decisions. We'd like to take this opportunity to debunk some common mutual fund investing myths:

Myths based on Incorrect Beliefs

When asked why the avid investor of stocks/shares does not take to mutual funds with the same passion and enthusiasm, the likely response is that mutual funds investments are dull and boring. They lack the thrill that one gets by investing in stocks. Bringing us to Myth # 1:

  • Mutual funds lack excitement

    "Who wants to invest in a staid investment like a mutual fund that probably grows half as fast as some ‘exciting' stocks like Infosys, ONGC or BHEL during a bull run?" The poser is relevant. Underperformance almost always gets the thumbs down, no matter what the reason. After all, every investor wants his money to work for him and if a stock does that better, why invest in a mutual fund?

    Yes, stocks can be exciting. And mutual funds may lack the excitement of a stock, but it's the kind of excitement that investors can do without for their long-term wealth as well as health. Mutual funds may not give an impetus to the investor's portfolio in a bull run like some ‘exciting' stocks. But, you can be sure that they won't burn a huge crater in the investor's portfolio either. Something that could be inevitable, should individual stocks be crashing by say 40%.

  • Mutual funds are too diversified

    "Mutual funds own too many stocks to be of any serious benefit. A focused portfolio of 8-10 stocks will generate a more attractive return than a mutual fund portfolio comprising 30-40 stocks."

    We are not sure if there is any theory to prove or disprove that concentrated portfolios (8-10 stocks) do better than diversified portfolios (30-40 stocks) in the Indian context. Of course, Mr. Warren Buffet has successfully managed a small portfolio over a long period of time. But, not too many investors can claim to have his investment discipline, insight and experience. In the absence of these important traits, it would be incorrect to expect a concentrated portfolio to outperform a diversified portfolio, at least over the long-term (3-5 years).

    Remember, fund managers are experienced money managers and their mandate is to outperform the benchmark index of the fund. And if these experienced managers have chosen the diversification route that tells us a little about how to go about making money in the stock markets.

  • Mutual funds are too expensive

    "Mutual funds aren't cheap. On an average, the recurring expenses for a diversified equity fund ranges from 2.25% to 2.50% of net assets."

    The 2.50% (maximum) recurring expenses charged by the mutual fund go towards meeting the brokerage costs, custodial costs and fund management cost. These are expenses that stock investors incur as well (barring the fund manager's salary). Consider this, when you have a competent fund manager who combines his time, effort and expertise to research stocks and sectors to pick his best 30-40 stocks and also buys and sells them for you, you have someone who is doing a lot of work for you and is charging only a maximum of 2.50% of your investments. Of course we agree that this must be followed by sheer out performance of the benchmark index and even peers. You don't want to pay for underperformance.

    The good news is that quite a few diversified equity funds have managed to put in what can be termed as ‘a very good performance' over 3-5 years vis-à-vis the benchmark index and peers. Which are these funds, you ask?

    Scheme 6-mth (%) 1-Yr (%) 3-Yr (%) 5-Yr (%) Since Incept.
    IDFC Small & Midcap Equity (G) -6.96 10.66 23.08 - 21.93
    ICICI Pru Discovery (G) -4.53 11.37 20.04 13.19 26.93
    HDFC Equity (G) -5.00 17.54 18.19 16.53 22.74
    Quantum LT Equity (G) -4.12 16.37 16.51 16.70 17.29
    Mirae Asset India Oppor-Reg (G) -4.50 11.91 16.41 - 17.86
    HDFC Top 200 (G) -5.22 15.70 15.81 16.65 23.27
    Reliance Equity Oppor-Ret (G) -7.62 12.26 15.74 13.45 23.40
    IDFC Premier Equity-A (G) -8.06 12.81 15.67 20.49 23.75
    DSPBR Small & Mid Cap-Reg (G) -9.06 12.88 15.53 - 13.99
    UTI Master Value (D) -6.32 14.86 14.42 11.81 23.22
    BSE SENSEX -5.34 8.48 5.02 10.05 NA
    S&P CNX Nifty -5.71 8.81 4.93 10.24 NA

    Performance as on April 18, 2011
    (Source: ACE MF)

    Note: PersonalFN does not recommend that the reader to transact in any mutual funds without doing the necessary research. The aforementioned table does not represent the recommendation of Personal FN. Readers are requested to consult their advisors / financial planners before investing.

    In sum, we'd like to say that investing your money is serious business, which is best done with a methodical approach. Mutual funds allow for that, and investors must try to benefit from them. At the end of the day, being a successful investor is all about making the most prudent investment decisions, even if they are dull and boring.

Myths based on Incorrect Facts

  • Equity funds invest up to 35% in debt

    Equity funds are commonly known to take on the investment mandate (mentioned in the fund scheme offer document) to invest up to 35% of their assets in debt and money market instruments. This in turn, leads investors to believe that the fund manager intends to use asset allocation as a strategy for delivering growth i.e. investors expect the fund to capitalise on opportunities from both the equity and debt markets.

    However in reality, most equity funds rarely use the mandate to invest in debt. In other words, the intention is to be a ‘true blue' equity fund that is almost entirely invested in equity instruments at all times.

    Equity funds invest a smaller portion (if at all) of their corpus in debt with the intention of curbing losses in a falling equity market. Clearly, benefiting from investment opportunities in the debt markets, by being invested therein at all times is not the intent. Investors who intended to invest in an ‘asset allocation' kind of fund are likely to be disappointed by their equity fund.

    The learning: Investors looking to invest in ‘asset allocation' funds should consider investing in hybrid funds (usually 65% in equities and balance in debt) or Monthly Income Plans – MIPs (usually about 20% in equities and balance in debt).

  • Funds with more stars/higher rankings make better buys

    Often, investors make their investment decisions based on the fund's ranking or the number of stars allotted to it. Fund rankings and ratings have gained popularity over the years; a higher ranking/rating is construed as a sign of the fund being a good investment avenue.

    Sadly, what investors fail to realise is that often rankings/ratings are based only on the past performance on the net asset value (NAV) appreciation front. Very few rankings/ratings in the market consider factors such as volatility and risk-adjusted performance. So the fund's NAV might have grown over the years, but with a very high risk factor.

    Secondly, rankings/ratings are known to change over a period of time in line with a change in the fund's performance. Does that mean investors should start buying and selling a fund in line with a change in its ranking/rating? More importantly, fund rankings/ratings operate on the rationale that one-size-fits-all. They fail to reveal who should invest in the fund. For example, if an aggressively managed sector fund notches the highest ranking based on performance, will it make an apt fit in a risk-averse investor's portfolio?

    The answer is - Clearly not! The fund rankings and ratings do not convey this to the investor.

    The learning: At best, rankings and ratings can serve as starting points for identifying a broader set of "investment-worthy" funds. But investing in a fund based solely on its ranking/rating would be inappropriate.

    Instead, investors should engage the services of a qualified and experienced financial planner who can help in selecting funds that are right for them. Remember to choose a financial planner who is fee based, which ensures that they will be unbiased and work in your interests.

  • Once a fund house makes the grade, so do all its funds

    "One swallow does not make a summer" goes the proverb. Similarly, just because a fund house makes the grade, it doesn't necessarily mean that all its funds are worth investing in. Typically, for a fund house to make the grade, it should be governed by a process-driven investment approach. Also, it must have a track record of delivering and safeguarding investors' interests at all times.

    Investors often make the mistake of confusing the fund for its fund house i.e. they assume that simply because a fund belongs to a given fund house, it's worth investing in. Such an investment approach is far from correct. It is not uncommon to find funds (from quality fund houses) that have either lost focus on account of persistent change in positioning or have fallen out of favour with the fund house itself, on account of their lacklustre investment themes.

    The result of the neglect (on the fund house's part) is visible in the fund's performance. Despite being exposed to the best investment processes, such funds fail to deliver.

    The learning: While the importance of the fund house is indisputable, the same shouldn't be seen as certification for every fund it offers. After passing muster at the fund house level, each fund must also prove its own worth, in terms of its investment proposition and track record across parameters.

  • A fund invests in the same stocks as its benchmark index

    A number of investors believe that a mutual fund always invests in the same stocks that constitute its benchmark index. For example, if the BSE Sensex is the benchmark index for a fund, then it is expected to invest in the same 30 stocks that form the BSE Sensex. This is true only in the case of index funds i.e. passively-managed funds that attempt to mirror the performance of a chosen index. In all other cases, i.e. in actively managed funds, the fund manager is free to invest in stocks from within the index and from outside.

    The benchmark index only serves the stated purpose i.e. benchmarking. It offers investors the opportunity to evaluate the fund's performance. Generally, a fund's success is measured in its ability to outperform its benchmark index. Secondly, the benchmark index also aids in 'broadly' understanding the kind of investments the fund will make. For example, a fund benchmarked with BSE Sensex or BSE 100 would typically be a large cap-oriented fund, while one benchmarked with S&P CNX Midcap is likely to be a mid cap-oriented fund.

    The learning: Don't expect an actively managed fund to invest in the same stocks as its benchmark index. While the benchmark index can prove handy in evaluating the fund's performance, it certainly need not form the fund's investment universe.

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