The big bad world of mutual funds

I made my first investment in mutual funds on Nov 5, 2004. It was a tax saving mutual fund.

Before that, I was investing in stocks too. I invested in a few including an IPO. But stock investing was too much to handle for me. Given my laziness I could never make the effort to build a decent stock portfolio. (Yes, I believe it takes work.) I sold the IPO soon after pocketing some nice listing gains.

Now, the next best option was investing through equity mutual funds. I invested these ready made stock portfolios managed by some of the best minds, read, fund managers.

It has been so far, so good.

However, for the last few weeks I have been thinking, in fact rethinking, my decision.

I have been evaluating the other side of mutual funds. Yes, they have a lot of good features but then every coin has two sides.  Here is what is going on in my mind. 

The markets have been rising. I don’t track the numbers, but I read somewhere it has hit the number 30,000. See, that’s the height of my laziness. I don’t even track the markets. I don’t even track my MF portfolio so often.

So, markets are at all time highs. Stock valuations are definitely expensive (if not frothy) on the basis of their P/E ratio.

Is this the best time to invest? I don’t know. I left it to the fund manager to decide. I have outsourced the job. Like me, many others have too.

The money continues to pour into the markets via mutual funds. The fund managers who typically have a mandate to be 100% invested at all times, continue to invest the fresh flow of money in stocks.

You see no fund ever stops taking fresh money when there are no opportunities. Yeah out of over 300+ equity funds, a couple of them do that. Another couple of them hold on to cash till they find enough opportunities. Fine. But what about the majority rest? They just keep investing – in the good, bad or ugly.

Now, given the size of some of the funds, will they end up just buying the market? Will my returns be any different from a broad market index fund?

Where is the alpha creation effort for which I am paying the fund management fees? I mean if funds continue to invest the money at any prices, my alpha is going to suffer. I am going to get average returns.

That brings us to the question why do funds continue to accept money?

Simple, the greed is at work.

Turns out that the salary, bonus, perks of all the mutual fund staff, specially the fund managers, are being paid from the expense ratio charged to the AUM of the fund. The larger the AUM, more the fees, more generous the perks and bonuses and the foreign junkets.

And the worst part is we are charged a fee irrespective of whether the fund does well or not. 

As they grow, they don’t forget to boast about being the largest, 2nd largest or 3rd largest. The bigness is still respected and given weightage to by a lot of investors. It brings them the headline coverage. It adds to the brand and it is a crucial selling point.

HDFC & ICICI Mutual Funds are already breathing down each other’s neck. Many other fund houses have a similar mandate – grow every way you can – become big.

To push the agenda, campaigns on marketing, advertising and selling expenses re done and the expenses are charged to us. That money they use is a part of the expense ratio. It is not the fund houses money. So, I bleed further here too.

Interestingly a lot of the sales expense to grow the fund size is done in the name of investor awareness. Investor awareness, my foot!

Then comes the size versus strategy problem. A small fund can practice a focused strategy and operate in a niche. But when it grows, it can do little but be a broad market fund investing in 100s of stocks. Sometimes the internal rules, sometimes those specified by SEBI, force it to do so.

Think ICICI Pru Value Discovery. The fund is not the same power as before. It made its name as a value oriented mid-cap fund. It is now a multi cap/flexi cap fund. Investors are still running it. I guess it is already the second largest fund in the industry.

Let’s talk about fund managers. Now even fund managers are human. With all the specialised knowledge they have, biases can hit them as much as any other ordinary person. They can mistakes or make a wrong judgement too.

Take a guy like Prashant Jain. He is considered the God of “fund management” in India and paid like one too. But even he had a bad run with the funds he managed. Was it wrong judgement or plain bad luck, I don’t know. The fact is the funds he managed were hit.

Now, leave aside this guy. How many other fund managers actually have the talent or skill to take care of so much money under their hood?

Here’s an interesting point. There are probably more fund managers at work than worthwhile stocks that one might want to invest in. Some peg this number of stocks at 200. For a broad market index fund it could be as much as 500.

Are some of these so called fund managers just getting by? Have they just filled up vacancies? Do they have original thinking or they are using copy-paste lessons from the MBA class?

Let’s not even talk about the number of mutual funds. The only relevant questions to ask towards that is how many differentiated investment strategies can truly exist? It can’t be 300.

Now, when I selected my funds, I did try to overcome all these objections by using subjective criterion too. And yes there are a couple of good funds that emerged. I can swear by them.

Yet, it is not all so hunky dory.

Hence, I have been thinking.

So, what am I going to do?

No, I am not dumping my funds. However, something needs to be done.

More on this later.

---

Between you and me: Here’s an article about a fund manager fighting a divorce case and who was told by the judge that his (fund manager’s) wealth was not a result of his professional brilliance but because he happened to be at the right place at the right time. Basically, he was lucky. Gosh!

What do you say?