Saturday, February 11, 2006

Do we need active mutual funds ?


Recently I came across a host of articles on how active mutual funds charge exorbitant fees to the 'gullible' investor. Dr.Shah has a nice article on this. One can read the same here. Couldn't agree more than what Dr. Shah had to say. But, obviously most of them go un-noticed so long as markets are headed north. While reading the article by Dr.Shah and what other commenters had to say about the same - it just struck me and I was asking myself a question - Who and why should one invest in active mutual funds ?

Who should invest -

a). Lay investor who has no understanding of equity markets and about companies. This list will include all those professionals (outside of the money mgmt biz), house wives, retirees, etc.

Now, the next question is - Why should they invest in mutual funds ?

To earn returns better than those doled out by fixed deposits, the NSCs, the GoI bonds. So far it's all fine. There is a need to get returns better than those offered by the aforesaid instruments. But, invest in active mutual funds ?

Hmm, here is where i've a little different view - I think there is no need for active mutual funds. A lay investor will be better off investing in index funds or exchange traded funds (ETFs). The reason I say this is because investing in mutual funds for a lay investor is analogous to investing in stocks, you still gotto identify the better of the lot fund. This is because not all funds outperform the benchmark indices in the long run. A lot of research has gone into this study and is best summed up in the book - A Random Walk Down Wall Street by Burton Malkiel.

How many of us have heard of mutual fund schemes that have consistently beaten the indices for a period of over 5-10 years. Not many, I guess. A few names that come to mind are - Morgan Stanley Growth Fund, Reliance Vision Fund and maybe a few others. Yet, we have whole host of funds floating in the market. Who makes by investing in those - surprise, surprise - the fund house.

What this means is that the onus of selecting the right fund scheme still stays with the individual investor, isn't the process same for investing in stocks ? And, if that is indeed the case, and the fact the lay investor does not know much about which scheme/stock to pick, isnt he/she better off investing in index funds/ETFs (passive funds). The other major advantage of investing in passive funds is lower fees. The only problem that the investor is likely to face is tracking error. I think it is still fairly high in case of Indian funds (Dr. Shah has written some very informative papers on this topic. I think the pdfs are available on his site). But, i think over time this is likely to come down.

The individual investor should always look at investing in better avenues than the archaic bank deposit. Yes, i know one can sleep well if the money is lying in the bank or that the value of the capital lying in the bank deposit does not fall (in the real sense, ofcourse). But, then I think it will be great for individuals to get some exposure to capital markets (by way of passive funds, ONLY). For those who strictly put their money into fixed deposits, or other GoI bonds, here is something to ponder -

a). A sum of Rs.10,000 invested in a fixed deposit in 1991 @ an average interest rate of say, 12 per cent, would have compounded into Rs.54,736. Such deposit rates will obviously be not available in the next, good god knows till how many years !

b). A similar amount in an index fund that tracked returns on the BSE Sensex would have compounded the initial investment into Rs.100,185. This is assuming a 'zero' tracking error. But, even if i assume a tracking error of '1%', the amount invested would still be significantly higher than Rs.55,000, much higher.

Ponder over this - If a GDP growth that averaged around 5-6 per cent (between 1991-2006) can produce such returns what should stop it from doing it again in the next 15 years ? Nothing can, If you ask me.

I think the numbers say it all. Those who cannot live with volatility and the gyrations of the stock market can, therefore, invest 30-40 per cent of their savings in index funds or ETFs. The rest can be put into fixed deposits/PPFs/NSCs..etc. But, invest in equity markets, one must. As even by allocating a 30-40 per cent of total savings into index funds, one can enchance returns substantially over the long run.

Thus, it is quite clear that active mutual funds are not the best options for the lay investor, so who is left ?

b). Companies/corporates.

This is one area where I strongly feel that companies that make large investments in funds (out of reserves, ofcourse) are doing a great disservice to the investors. Companies like Infosys, Bajaj Auto, Wipro, etc. are sitting on billions of rupees of cash in their balance sheets. And, all of it is invested in active mutual fund schemes. Conservatively many of them invest the same in income (debt schemes) or balanced funds (equity + debt schemes). Returns from these would be a paltry - 10-15%, at best. Whereas the RoCE for most of these large companies is in excess of 20-25%. Aren't these companies and therefore their shareholders better off investing in their own businesses (where the returns are higher) and if not give the money back to the shareholder. Why keep'em with the mutual funds, who charge nice fat fees for a mediocre performance.

Thus, I think the companies should not invest in active mutual funds.

These two groups are the largest investors in active mutual fund schemes. People like me who -

a). Do not believe that the markets are efficient (as the efficient market theory suggests),
b). Think that markets can be outperformed in every run (short or long), provided one trades/invests/speculates with discipline and some intelligencia.

will never look at investing in active mutual funds. I think only the RBI should invest in actively managed mutual funds (not in India but in the US, instead of buying their treasuary notes which yield a paltry 4-5%).

So, does one still think that there is a need for active mutual funds ?

9 comments:

Aditya Ramachandran said...

Most of the data I read was about the US markets and involves broad indices like S&P500. I do get the efficient market theory but just that index funds in India do not represent the average market return since they track the narrow sensex or nifty. I figure, though, that index funds in India can be used as a large-cap fund replacement. Besides, you're buying the 50 best companies (nifty) in India in one shot with zero load to boot.

Tiberius said...

While I agree with you on the need for one to use one's finances more efficiently, I disagree about the agruement about the perils of investing with Mutual Funds.
Let me try to make my point. If an individual is interested to invest (in any asset form), one has to make an of effort to familiarise ones self with that asset class to make meaningful decisions.

THERE IS NO SUCH PERSON AS A LAY INVESTOR.

Yes people start of as novices but they do graduate to higher levels. The learnig curve slope. If cost was the only factor then yes MFs are an expensive option compared to ETFs but even investing in the right ETF or Index Fund makes a huge difference. For Eg: The Sensex gave a return of 42% while the MSCI India ETF gave a return of 25% (currency adjusted) for the period 01Jan05 - 31Dec05.
An investor also has to take a call on which market, industry, sector to invest in, so a certain amount of knowledge, market view is always prevalent. Here we talk of Investors and not speculators.

Labelling Investors as Lay and then expect them to invest more of their savings in an asset class which without knowledge and view would be similar to a gambler on a slot machine. Content to get his investment back, estatic to hit a jackpot and blaming the machine for losing his shirt.

Give a man a fish and he will eat for a day, teach him to fish and he will eat for ever.

Ravi Purohit said...

Tiberius,

Well, if investors (individuals and corporates) were capable of doing what you said they can (or rather do) then it would strengthen my argument further that 'there is no need for active mutual funds'. Mutual funds were meant to offer diversification and one can easily get the same from index funds or from ETFs that track such indices.

I think what Aditya said was right, index funds in India still offer only a narrow basket of companies (ie. tracking the Sensex or the Nifty companies). They should begin offering index funds for the Nifty Junior as well (the next best companies on offer).

Personally, I think the best index fund is the one which tracks the entire 'investible' market. One that covers the entire population of stocks. One might argue that it will lead to higher trasaction costs, but the beauty of creating such an index would lie in its construction, that minimises transaction costs.

Awaiting the day when we get our own 'Wilshire-5000' index in India.



PS: The term lay investor refers to a person who does not belong to the investment community, meaning does not have much knowledge/time to research a stock/scheme.

Tiberius said...

Having a view/comment on a sector/industry/country is proof of having some knowledge.
If one does not invest some time to find out investments avenues then one should stick with FDs

Naveen Mandava said...

This may be useful for you!

http://bigpicture.typepad.com/comments/2006/02/seven_sins_of_f.html
Good blog, keep it up and do keep it simple for those still learning the ropes.

Ranjit said...

i think, we need to find an alternative to the concept of mutual funds, at least for the lay investors! This is not going to be easy as the fund managers would definitely not like to axe their own roots!!

what's the alternative?the investment system as a whole should emphasize on making lay investor capable of taking (more) thorough decisions. this will take time and can't be achieved with the help of a day's training session.

to give an example, i consider my father as a lay investor. to my best knowledge, he won't be able to figure out what a person means when he says P/E or beta. he is equally unaware of mutual fund schemes (though he knows the concept of MFs). But, i consider him as a patient and yet shrewd value investor. He had started investing in IPOs in his mid-thirty's and he was never ever involved in secondary market transactions as that was an unfriendly terrain for lay investors (with absolutely no transparancy whatsoever- i'm talking about 70s and 80s). and not all his baits were pieces of gold. some investments evenually reduced to penny-size. however, he did hunt some big fish. and mind u, they were not as big at that time as they are today. most of his decisions were a function of knowledge he got from newspapers about the companies that floated IPOs and his gut feeling.

the latest example of his successful investment (at least so far) is Shree Renuka Sugars IPO. the scrip is trading at more than 3x of IPO price. again, there was no reference to P/E or expected EPS he made while going for it. He was also in favour of follow-up offer of ICICI bank and buying ACC from secondary market after the Holcem deal (at about Rs.380). Both these baits, as u can see were fruitful within a short span of time.

i think he's honed his skills unknowingly by taking chances, lot many of them. each time he invested as much as he could afford to lose in a game of poker.
if he gets some technical knowledge about evaluating stock, perhaps that will add to his expertise.

i believe, every human being is born with ample appetite for risk. blame it on the environment which conditions him to be risk averse. instead of scaring the lay investor away from the market and offering him so called less risky MF option, need of the hour is to give him confidence that he is able to take calculated risks. and, anybody and everybody is free to fail. faliure is not a sin as long as a lesson is learnt. lose...but don't lose the lesson!

Roshni D said...

Volatility is not an issue for somebody who is investing in a well known active MF scheme. MF NAVs are not subject to the kind of volatility witnessed in equity stocks on a regular basis. Also, considering the present scenario, if u want to earn a decent 20-30 pc returns, u need to stay invested in an active MF scheme atleast for a year. By the way,
a layman investor also has the option to
invest thru the SIP route to average out his cost. The track record of SIPs is well known. For many of the reputed MF schemes I have come across, SIPs have been an outperformer. Currently, the valuations of most of the index stocks look stretched. A lot of action in the coming yrs will be in mid caps. The fact that nearly 6-7 mid cap schemes have been launched over the past 1 year proves this. Mi contention is that
a layman person shud invest in active MF schemes, of course in the ones with a proven track record.

Ravi Purohit said...

Roshni,

Your last statement said it all -

"Mi contention is that a layman person shud invest in active MF schemes, of course in the ones with a proven track record."

There in lies the moot question - How does a common investor (individual/corporates) find an active fund with a proven record ? There has been plenty of research world over which proves that a fund which does well in period 't' does not necessarily perform well in time 't+x'. In India, the case is almost the same. Cant remember names of funds that have consistently outperformed the benchmark indices. There a handful and that is it.

Unfortunately you and I may know this because we have access to plenty of financial market information, but there are many who do not. And as a result, they really do not know which mutual fund is the better one (infact frankly if someone were to ask me what active fund to invest in today's time, I will not have an answer).

This is why I increasingly feel, investing in equities should be as seamless as investing in a fixed deposit. And, index funds are one way to go about it.

Ravi Purohit said...

Naveen,

Thanks for the link. The pdf looks interesting will read it.

-
Ravi.