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 ?