Performance of Indian Mutual Funds

It would be an understatement to say that the past 3 years have been interesting for investors. What a roller coaster ride! From 10,573 (3 years ago), the Sensex went to an all-time high of 21,113 on 9-Jan-08, touched a low of 7,697 on 27-Oct-08 and it has gone back up to 13,887. Overall, the Sensex gave 9.5% compounded return in the past 3 years which is not bad because long term capital gains are tax free. On top of it, you would have got from 1% to 2% as dividends per annum which makes the returns more than those available in fixed deposits.

The period is interesting to analyze because such sharp movements are a rule rather than an exception in the equity markets. These are the periods which separate men from the boys. When the market is showing what folks at CNBC call a secular uptrend, the investors who bought, with our without reason, perform better. When the markets are falling, your grandmom with all her savings under her carpet will outperform you.

In the Indian context, the period is even more important. When the Sensex crossed 10000, it became a topic of front page headlines in the national dailies. There was nothing sexier than the Sensex and many investors, who had so far resisted the lure of a forbidden fruit, entered the market. These new investors weren't the ones who should invest in equities in the first place because their definition of long term coincides with that of the Indian tax department…One year! [This is amazing because I can't think of any business whose projects have a gestation period less than one year…except may be the booming Indian business of procreation]

From the shady bylanes of Bharuch to sparkling tech parks in Bangalore, stocks became a topic of discussion. I'm not saying that investing in stocks is bad. After all, if the inhabitants of the country won't participate in their country's march towards prosperity, foreigners will and soon every profitable corporation will be owned by foreign investors. But what these investors need to invest in is the right advice.

In all countries (including India), mutual funds play a big role in channelizing the investments from investors into good businesses. India too has a booming mutual funds industry. They have a mandate to make the investors prosperous and they claim they will… in no time.

The results, however, are saying something else. In the last 3 years, 78.44% equity mutual funds underperformed the 9.5% p.a. return from the Sensex. The median return was 5.28%. In the balanced funds, 78.78% funds underperformed the Sensex and 81.12% debt funds gave returns lower than 10% of what was available from Fixed Deposits during this period[1].

If you invested in mutual funds, you've got to get angry. These MFs charged you 2-3% of the money invested per annum and what a lousy result.But your anger is unjustified. You should have known better. You were screwed the day you bought the mutual fund. The world knows it. Forty years ago, when people collated decades of performance data, they found that more than 70% of fund managers underperformed the indices like S&P 500. This shocking result led to the rise of low cost Index funds and a highly costly Efficient Market Hypothesis (EMH).

The former relied upon a passive investing approach by investing in stocks in the same proportion as the weight of the stock in the benchmark index and thereby reducing the 2-3% fund management costs to close to zero. It was a huge success.The latter, i.e. EMH, theorized the empirical observations. Efficient Market Hypothesis claimed that it's not possible to beat the indices consistently because the markets, always, price the stocks efficiently. Forty years on, the investors like Buffett have proved the theory wrong with a simple common sense approach to investing but that doesn't stop the bogus hypothesis to be in curriculum, in analysis models and in the investing strategies of mutual funds.

There are two things which are very clear about the mutual funds. (1) They charge exorbitant cost ranging from 2-3% of the money for delivering this lousy performance. (2) The very structure of the mutual fund prohibits them from being able to outperform the general market.First, on the cost part. If a fund is delivering 30% per annum compounded and charges 4.5% per annum, you still make 25.5% compounded. The fee is well earned. If the fund makes only 13% and charges 2.5% p.a. for this, you are getting only 10.5% per annum. That's not enough incentive to subject yourself to market risk. You are better off by investing solely in fixed deposits. You are better off by investing in Index funds.

Secondly, the inevitability of underperformance. In 1997, when I had less than 3 years of experience in investing, I read an article by Paul Krugman: ‘No Free Lunch; Seven Habits Of Highly Defective Investors' [2]. These habits, as per him, are

  1. Think short term
  2. Be greedy
  3. Believe in the greater fool
  4. Run with the herd
  5. Over-generalize
  6. Be trendy
  7. Play with other people's money
I really liked what he wrote. I realized that mutual funds have all these habits and some more. In my life, I never invested in mutual funds (except making a killing by buying close ended funds quoting at deep discounts close to their maturity date). But I didn't sit quiet either, sucking my thumb, quoting EMH profs., "you know, it's impossible to beat markets". Looking back, I feel happy that I did what I did. (In 2008, Paul Krugman won Nobel Memorial Prize in Economics).

In addition to Krugman's list, the structural problem with mutual funds is that they get the highest amount on inflows when the markets are at their peak and they face huge redemption pressures when the markets are close to bottom. In sector specific funds, they mop highest amount of funds for the sectors that have given huge returns in the past few years and that are overheated. This is recipe for disastrous performance. (That being said, I must note that in India, during last 3 years, all closed ended mutual funds and 21 out of 25 tax saving funds underperformed the Sensex. The more free hand you give to them, the more they underperform).

There is also a problem of incentives. From the point of view of an asset management company, the most successful mutual fund is the one which makes maximum money for them. You are incidental. The size of the fund is the key concern for the fund manager, because the expenses are charged on the invested amount. The mutual fund investors usually rank the mutual funds and invest in those with highest returns. This means that a fund manager has to focus on being among the top ranking during the upmove of the market because that's when the deluge of funds begins. You don't have to care about safety because no investor likes to exit at loss. This makes the whole proposition speculative and that's the reason why the mutual funds under-perform in the long run. In fact a careful look at the data will show that the performance of past few years does not guarantee above average returns in future.

What are the options for investors who don't know enough to invest themselves? Invest in index funds? I can't answer this in affirmative. The indices in India are heavily concentrated into few stocks and they are highly volatile. There is no index like S&P 500, because the quality of companies rapidly degrades as you go towards bottom of the pyramid. That's why you would see that Nifty Junior is even more volatile index.I've a simple advice for new investors. If you have to invest in equities, directly or indirectly, you have to learn few basic things about investing. Devote the next 5 years of your life to learn investing. You don't have to quit your job for it. You don't have to devote more than an hour to it, reading newspapers, business magazines and books. Don't worry about discounted cash flow valuation. Learn how to analyze the strengths and weaknesses of the businesses around you. Observe how powerful HULs brands are. Observe how ITC is investing heavily in FMCG and how long has it taken for the company to break even. Guess what will happen in the next 5 years. Analyze the results. This is what investing in stocks takes because a stock represents part ownership of a business. Your percentage returns in stocks of a company are not different from the majority owner. Then why should people think about stocks differently?

Theoretically, beating a leading index like Sensex isn't difficult. If you allocate your portfolio to same stocks as in Sensex, in same proportion as the weightage of each stock, you can match the returns from market. To beat that, all you have to do is to allocate a little less to a company that you think is below average and allocate that extra money to a company that you think is above average. That simple change will put you ahead of 78% mutual funds. But in reality, it's not that easy. Those very companies whose weight you reduced may outperform the index. That's why you need some bit of business knowledge so be able to make informed changes. Even if you never reach the confidence level to invest on your own, you will be able to at least check the portfolios of your mutual funds and check if they are taking unnecessary risk. Remember, if you don't know about investing, you can never judge whether your fund manager knows anything about investing. In such a case, every rupee you invest is stamped with "In God we trust" like the one US dollar bill.


1. Mutual Fund Performance Data

2. No Free Lunch; Seven Habits Of Highly Defective Investors
PAUL KRUGMAN, Fortune 12/29/1997


Siddharth Shukla said...

Great Article kamlesh it totally makes sense. I lost a lot of my money by investing in MF's like reliance power which had outperformed in the bull market but got thrashed in the bear phase. I invested a lot of my money earned during my internship(most of my friendz blew that money, i thought i was smart by investing it) in MF's when the market was at arnd 20 k levels and all thos funds are now down.Luckily once i started working i started investing a part of my salary on my own in the stock market and i came across buffet and value investing and from then on its been a nice sharp learning curve for the past 6 months(i still have a lot to learn) and i have made nice returns in the present rally to more than compensate for my losses from MF's. However i want to know about your views on the Benchmark S&p CNX 500 index fund which is on similar lines as bogle's Vangaurd S&p 500 fund. Also another misleading practice i have observed in the indian MF industry is that the fund's mislead people by using names like Contra,Value,Dividend yield. But when you have look at there portfolio's u find that most of the top holdings are similar and in no way contra,value or high dividend yield stocks. Further the fund management charges are way more than that in US , even for index funds. Blog Search Engine blog catalog EatonWeb Blog Directory Bloggapedia, Blog Directory - Find It! Blog Directory Directory of Investing Blogs Blog Listings Superblog Directory