Friday, 31 January 2014

What Fund Managers and Advisors won’t tell you

Everybody wants to benefit from growth. Everybody wants to benefit from movement in interest rates. Everybody wants to get the best returns for their surplus funds. In short, everybody wants the best returns for their investments. But, everybody does not know how to achieve it. The simple answer put forth before a common investor is “mutual funds”. Since, they offer professional fund management with even a small investment amount; it is the answer to many investor’s problems.

However, do the fund managers and mutual fund advisors and distributors tell you all the facts relating to your mutual fund investments. Or there are some things which they may not state. Let us examine those facts which a mutual fund manager or advisor may not tell you.

The mutual fund manager or advisor may not tell you that:

Hidden Fact 1: Expenses eat into your returns
A mutual fund may have lot of expenses like fund management expenses, loads etc. Although, these may appear to be small but over a long term, say 10 years, they may eat into almost 20% to 40% of your returns. Hence, you are paying high costs for fund management and distribution and if the fund does not generate that much “extra return” on your investments then you are simply paying high costs for sub-optimal performance. Kindly note, it the financial world, poor performance does not come cheap, you have to pay dearly for it!

Hidden Fact 2: Fund NAV is meaningless
The investor will not be told that the fund NAV (net asset value) in itself is meaningless. The typical investor feels that a fund with a lower NAV is cheap compared to a fund with a higher NAV. There is nothing further from truth. This blunder is because the investor neither understands nor appreciates the difference between price and value. A MF unit in itself has no value – it is “not” an asset like a house property, bond, equity stock, gold etc. Yes, the MF unit in itself simply has no value on its own – it derives the value from the underlying asset which it owns. The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units.  The corollary to that would be that a MF unit can’t be costly or cheap – it is not an asset in itself which can be costly or cheap – it derives its value from the underlying investment. If the value of the underlying investment goes up then the NAV will go up and vice versa. For example, there are two funds – A and B. Now, the NAV of Fund A is Rs.10 per unit while the NAV of Fund B is Rs.50 per unit. Does this mean that Fund A is cheaper than Fund B. Not at all. The NAV simply means that Fund A is holding such assets in totality which when divided by the total number of units results in a NAV of Rs.10 and ditto computation for Fund B which results in NAV of Rs.50. Further assume, that the portfolio of both these Funds is exactly the similar. In that case, a 20% rise in the value of the portfolio will result in a commensurate 20% increase in the value of the NAV of the Funds – Rs.2 in the case of Fund A while Rs.10 in the case of Fund B. This is another derivative of the first two mistakes – an investor can’t become more foolish when he / she invests in a MF NFO simply because it is available at “par value”. As explained above, the MF NAV is meaningless in itself as it is merely the value of the underlying asset. Hence, while investing in MFs don’t look at the price of the NAV but rather the underlying value which is derived from the portfolio of the Fund.

Hidden Fact 3: You can lose money in Fixed Income Funds
You may not be told that you can lose money in Fixed Income Funds. The name is fixed income but the income from it is certainly not fixed. There are different types of risks associated with fixed income securities like credit risk, interest rate risk, yield curve risk, basis risk etc. The most common risks which an investor attaches to fixed income investments is credit risk. Having said that, there is one more risk which is as important as credit risk i.e. interest rate risk. Few people understand this risk. If you are investing in long duration Income or Gilt Funds than you are at the mercy of interest rates. And interest rate risks is directly associated with the maturity of the security – the higher the maturity the larger the interest rate risk associated with it.

Hidden Fact 4: Income or Gilt Fund will be able to beat a normal debt product only if interest rates were to fall
This is another hidden fact which you may never listen. Income Funds are nothing but interest yielding debt products. But, when someone deducts high fees from the interest rate then what would happen – substantial fall in the income yields. That is what happens with income funds which are loaded with high fund management expenses. Hence, investing in income or gilt funds is nothing but paying heavily for buying an interest paying security and then hoping to earn capital gains on it!

Hidden Fact 5: Liquid Funds offer risk free returns
This is another misconception in the mind of investors which is merrily exploited by mutual fund managers and distributors. As mentioned earlier, there are different category of risks while investing in debt funds. A liquid fund may have negligible interest rate risk since it runs a very short maturity but it certainly has credit risk as it primarily invest in corporate papers. And mind you, for getting 5 to 10 bps of higher return, many times a fund takes unnecessary and avoidable risk of investing in not the best quality of papers. A liquid fund is for parking surplus funds and an investor would not want his capital to be put at risk for getting a few basis points of higher return.

Hidden Fact 6: Ignore Index Funds
This is another very common mistake which MF investors commit – ignoring a simple low cost index fund in favour of the high cost actively managed fund. And generally nobody encourages or advertises an index fund. Why? The answer is simple – the fund management fees are minimum in an index fund. Remember that it’s very difficult, if not impossible, to beat the stock market indices consistently over a long period of time. If that were not the case, then why over periods of a decade or more, approximately 75% of all “actively” managed stock funds underperform the passively constructed stock indices. The fact of the matter is that most people have no reason whatsoever to believe that they can pick winning stocks or time the markets and their success at it would be the same as it would be like throwing darts at the financial pages. I would like to quote Dr. William Bernstein who told that “there are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know where the market is headed. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know where the market is headed”. Nothing more succinctly explains the real world of professional investing and stock picking. Mr. Merton Miller, Nobel laureate and professor of Economics of Chicago commented that “if there are 10000 people looking at the stocks and trying to pick winners, one in 10000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful, but they’re really not”. Then I would quote Mr. Rex Sinquefield, co-author of Stocks, bonds, ills and inflation that “we all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it”. Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices! The conclusion therefore is that there is no reason for you or anybody else to believe that they can pick winning stocks or time the markets. Hence, the best solution for any equity investor is to stock into low cost passively managed index funds because year after year they would beat atleast 75% of the actively managed funds and over the longer term in most probabilities beat almost all the funds. But unfortunately, you may not receive this simple advice from most of the fund managers and distributors.

Hidden Fact 7: SIP is the best route to investing
SIP or Systematic Investment Plan is a popular term promulgated by mutual funds, their distributors and financial planners as a safe and sure route of investments in equities to outperform the markets and create wealth over the long term. SIP is certainly safe for mutual funds and distributors because they get committed continuous money for the long term on which they can earn fees and commissions. It is also safe for the financial planners to recommend because if anything goes wrong then they can blame the SIP system. However, for an investor, it is just another method of investing. It has its pros and cons. SIP works the best in a bull market or a volatile but rising market. On the other hand, SIP under-performs in a bear or sideways market.

Hidden Fact 8: Fund Churning is injurious for long term wealth creation
You may generally not receive the advice that “fund churning in injurious for long term wealth creation”. Instead, fund churning might be a popular advice showered on you by your MF Distributor. Instead of churning your fund just churn the MF distributor who gave you that advice. Distributors love the churning game – simply because it gives them extra commissions and fees while it gives you extra income tax, expenses and most probably a sub optimal fund. But the worst aspect of trading funds is that it allows the counterproductive emotions of investing to supersede the productive economics of investing. The dream of a perfect plan will never come true if mutual funds are traded as if they were stocks.

Hidden Fact 9: Owning too many funds
Usually you may not be advised to limit the number of funds you own. To paraphrase the old adage, "too many funds spoil the perfect plan." Why should this be so? First, the more funds you own, the greater the chance that a truly inspired fund selection will have its success spoiled by another fund that falls on its face. The problem has been called "diworsesification," for it leads investors to build a portfolio of funds containing so many individual stocks that it becomes contradictory for the holder. Even more counterproductive is the active trading of mutual funds. Typically, an investor today holds funds for but three years, an absurdly inadequate time frame for appraising the results of an investment program that should be inherently long term by nature. What is worse is that the funds may have been ill-selected in the first instance—funds with inflated performance, funds investing in hot market sectors, funds advertised on television, funds that trade actively and relinquish much of their profit to taxes, funds with high costs that didn't seem to matter when their past records looked so good.

Hidden Fact 10: Fancy Funds, fads and fantasies
Many new funds and schemes prop up during times of exuberance. Banking Funds will be launched when banking stocks have performed well, infrastructure funds when the infrastructure stocks are rising or IT funds when the technology boom is underway, so on and so forth. These sector funds are simply smart tactics to collect money from the gullible investors. No sector or theme continuously performs well over a longer term. Even worse than it, a sector fund is generally launched after the sector has already performed well because the fund has to show good past performance to attract fresh investor money. And by applying the “law of averages”, it becomes more likely that the sectors which have already performed well in the past will actually not perform so well in the future. Hence, never fall prey to fund gimmicks and invest in sector or theme based funds.

To conclude, you may not hear everything you should be hearing in regards to your mutual fund investments from the fund managers and advisors. However, reading and thinking between the lines would greatly aid you in recognizing the hidden facts. And once the hidden facts come fore to you, don’t pretend to hide behind them. Instead pay attention to them, try to listen to what message it has to offer, learn from them and go on to become a more clever informed articulate mutual fund investor.