Should you trust your mutual fund manager?

A request for people who are reading my articles for the first time: Please start reading the articles in chronological order – First article First. This will ensure that the concepts presented here are easy to grasp and the continuity is maintained.

A number of people have contacted me asking whether they should invest in mutual funds and what are the risks associated with a mutual fund. Well, most of the people are well educated about mutual funds so I’m not going to list the advantages (diversification, professional management, etc.) and disadvantages (market dependency, historical return do not guarantee future returns, etc.) of the mutual fund investment. You can find a lot of articles that talk about them, majority of them available on finance websites, primarily talking only about the benefits of Mutual Funds, as most of the articles are written by financial experts who work for finance companies and want to earn handsome commission for selling more units of their fund. Majority of them can be found on sites like rediff.com, moneycontrol.com, personalfn.com with jazzy titles like “Invest 10,000 now to retire Crorepati” or “Save big on tax by investing only 10K”. These articles carry some data tables, showing how an investment in so and so scheme could make you a crorepati by the time you retire, or how much tax can you save if you get into a Insurance plan for 25 years. The website at the end of the article, puts up a disclaimer saying that views expressed here are of the author and website does not take any guarantee for investment based upon the suggestions. Same thing goes with the advisors who come on Business News channels. Such articles with these flashy titles but highly inaccurate data serve multiple purposes:
• Jazzy titles make a person click on the link. This adds to the website revenue, by showing ads – More profit as more people visit the pages
• The Author or the so called “Investment Expert” or “Certified Financial Planner” gets to promote his concept (basically his product- Insurance scheme, mutual fund) to millions of people
• The website adds a message board at the end of each article – Visitors start publishing their “intelligent comments” and fight with each other over what is better or worse, what is wrong or right with the article, what is the best investment strategy and so on. All this results in millions of webpage hits: Net result – pretty good profit for the website, which is also shared with the author.
• Now a days, the authors also provide their email address, so that people can contact them directly. The psychology that works here is as follows: People believe the author is a real expert – that’s why he is able to publish his articles on reputed websites, so they contact him for his expert advice and the response that comes in is for an advice to invest in that particular scheme. I tried contacting a few of such authors pointing out mistakes in their calculations in their articles. The response I got was not answering my questions, but “XYZ scheme is very good and reliable, please invest in that, you will definitely make good money”.

You may be wondering what is the reason I’m quoting all these things here, and how do they relate to the title of this article? Well, I’m attempting to establish the link on how an investor’s decision is influenced, given the free and easy access to information/advices on internet and television.
Why is the Mutual Fund Manager interested in managing your money? If he’s such an expert, why doesn’t he keep the money making secrets with himself and keep trading for himself making great profits. Obviously he’s not doing it for charity. You have to pay him a commission- that either comes in the form of “Entry Load” and “Exit Load”. This is the commission that also pays for the advertisement of Mutual fund and payment to various agents who are willing to come to your office/home to fill up the forms for you and take the Cheques for investment money –all services appear to be free with home delivery.
Usually, when a fund comes into the market, it comes through NFO or New Fund Offer (equivalent to IPO for stocks). People subscribe to it by investing their money. For any mediocre fund, it is not difficult to collect around 800 crore rupees from the market. Established fund house like HSBC managed to gather as high as 1700 Crore Rs. for their single fund in 2003. The mutual fund manager takes a percentage of this collected money as his commission to manage the fund. It usually lies in the range of 1.5% to 3%. Now, for a very mediocre fund that collects 800 Crores from the market, the fund manager at a rate of 2% takes home a whooping 800 *2% = 16 Crore Rs every year! The remaining amount of commission collected in the form of “Entry/Exit Loads” is used to pay to the agents and for advertisement and promotion of the fund. In essence, everything comes from your pocket. If you see a full page ad in newspaper for a Mutual fund you’ve invested in, it is you who has paid for it.
Each of these ads, either on TV or in newspaper, carries the famous tagline: “Mutual Fund investment are subject to market risks, please read the offer documents carefully before investing.”

So now, when the fund manager is pocketing such a huge amount of money (16 crores each year) even for a mediocre size fund (800 crores), why is it that he CANNOT guarantee even a 1% profit? Forget about the profit, he cannot even guarantee the protection of your principle amount that you give for investment in MF.
The reason – Having decades of experience in the market, the fund managers (and all the mutual fund companies) know the dangers of stock markets. They are well versed with the risks, downturns and the panic periods that may come anytime. They know that markets work randomly, their direction is unpredictable. The regulatory authorities like SEBI, also know the risk in stock market investments, so they have implemented this legal requirement for mutual fund companies. Recently, you may have heard a lot of controversy over investment of Provident Fund money into stock market, which is opposed by many politicians and economic experts. Its due to the same reason, the government has the liability of Provident Fund money, it does not want to suffer losses if the PF money invested in the stock market going for a toss. That’s why there are proposals for only a small percentage of PF money to be allocated to investment in stocks.

Now I want to ask the same question to people who claim to make 15-20% profit on their individual investments in Stocks. If the Fund Managers and Companies with decades of experience cannot guarantee even the protection of your principle amount, where do you stand when you say that you can make 15-20% profits year-on-year? What is the basis of your justification and calculations?
Then, some of you claim that a minimum 15-20% annual profit is guaranteed if you invest in the so-called BlueChip companies. I’ve already attempted to prove that we cannot differentiate between good and bad companies in a previous article. However, if you as an individual are so sure of making even atleast 10% profits by investing in so-called bluechip companies, then even the fund managers can invest in the same bluechip companies – still why they do not guarantee anything? The reason is same – highly uncertain and unexpected market behaviour at unexpected times even for the so-called blue-chip companies.

This also takes us to question for another commonly heard term – diversification and asset allocation. One of the major benefits of mutual funds is diversification which eliminates the risk of putting all the eggs in one basket. Asset Allocation is also linked to the same concept of diversification, additionally it takes into consideration the percentage money allocated to different stocks in the portfolio. Even a small size mutual fund will have a MINIMUM of 60 stocks in its portfolio at any given point of time. Now, when the mutual funds have this diversification and asset allocation as one of the major plus points with them, why still they cannot guarantee any profits?

Mutual Funds also give the advantage of PROFESSIONAL money management – which implies that educated and experienced professionals take care of your money. However, still the question remains the same – why no guarantee of profits?

I usually do not present anything without facts: So let’s have a look at the performance of fund managers (Stock-Equity Funds) over the period 1986 to 1995, as compared to the rise in the market. (Graph at the begining of this article – You may open the graph in a new window for better viewing).

The graph shows how much the returns generated by the fund were LAGGING behind the returns generated by Market Index during each year. For e.g. in 1989, if the Market Index (S&P 500) made 100% profits, then the equity funds for the same period were lagging behind the market by 82%, i.e. the equity funds made only 18% returns as compared to 100% returns from the market. If the market went up by only 10%, then the equity funds produced only a 1.8% profit. Even in the best case, in year 1993, the graph is showing only 40%, which means if the market went up by 100%, the equity fund went up only 100%-40% = 60%.This was the best case scenario with respect to the equities fund. The most IMPORTANT of all: The last bar graph shows a summary of entire duration 1986 to 1995 – indicating that during the overall 10 year period, on an average the equity fund could manage only 100%-80% = 20% returns as compared to a 100% market returns.
Obviously, if in any year the market went down, the mutual fund was down further with much bigger losses.
One thing to note here is that the performance calculated above was not for any particular fund, but the average return generated by all the available equity funds was taken into consideration. As of today, there are more than 3600 funds available in India alone (Source Association of Mutual Funds of India - http://www.amfiindia.com/). Which MF can you choose, how will it perform, how will the fund manager act with your money, NOTHING is certain. In Holland, where I did my Masters Studies, there are more mutual funds available, than the no. of stocks listed on the Amsterdam stock exchange. If it was so easy to make money in the market, everyone would make money just by investing in these funds or by going for diversification at individual levels.

The fact is that there is no individual – educated or experienced, uneducated or naïve, businessmen or layman, trader or fund manager – absolutely no one can guarantee anything in the markets. Hundreds of factors play role in the valuation of the stocks. Predicting them is a dangerous and highly inaccurate error-prone task. If you believe that you are doing the right selection of stocks at your level, the fund managers atleast have some advantage over your inexperience and ignorance. They have much more money than you to play around with. If you “Invest for LONG TERM”, then every single fund also advises individuals to invest for long term, & the mutual funds carry on for long term. And still the fund managers fail, without guaranteeing anything. How can we, INDIVIDUALS, be so sure of making sure shot profits?
Once again, let me reiterate - Things work RANDOMLY. It’s a risky business; make sure you understand the risk for your hard earned money before jumping in.