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How to get Real Gains from Your Mutual Funds - IndiaNotes.com
How to get Real Gains from Your Mutual Funds
Multi-Act Equity Consultancy | Published: 20 Mar, 2017  | Source : IndiaNotes.com

The article was authored by Mr. Rohan Samat, CA and Ms. Mansi Desai, CA of Multi-Act Equity Consultancy Pvt. Ltd.


Fact: Market returns from investing in equities is much more than the returns an average Mutual Fund investor actually earns.


The analytic group ‘Dalbar’ has two decades of experience in the U.S. market, and publishes reports comparing performance of an average Mutual Fund investor vis-a-vis Market Indices.


Their recent study of a 30-year period ended 31 Dec 20151 calculating yield to the U.S. investor in a Mutual Fund (not of the Mutual Fund itself) revealed that the average equity Mutual Fund investor obtained a return of only 3.7% whilst the S&P 500 delivered 10.35% compounded annual return. Similarly, a 2015 ‘BlackRock’ study showed the average investor earned only 2.11% over 20 years.2 Fidelity reported the same.


In our own study (by Multi-Act), of a 10-year period up to 31 March 2016, Indian equities gave an average ROI of 4.4% to the individual investor (see Chart 1 below).


Reports analyzed were from the Association of Mutual Funds in India (AMFI) for outflows, and Internal Rate of Return (IRR) into Mutual Funds, to calculate the average individuals IRR of fund flows in an SIP.


Chart 1: 10-year Market Return vs. IRR of MF Investor



Why is there a huge gap in Underlying Asset Class Performance and Actual Investor Return?


In the U.S. as studied by ‘Dalbar’, and in India, analyzed by Multi-Act, the investor often has both his entry and exit times wrong(Table 1, below).  Investor and fund manager decisions are also easily influenced by common market sentiment. Behavioural biases (http://money.usnews.com/money/personal-finance/mutual-funds/articles/2015/05/26/7-behavioral-biases-that-may-hurt-your-investments) play a definite detrimental role.


Table 1: Mutual Fund Inflows and Returns



Routinely, most net inflow to Mutual Funds happens when the market seems good but is actually expensive (>1.25x Price to Fair value), and when the Sensex/Nifty recedes below fair value. Mutual Fund managers also go with sentiment, and investors need to understand hidden risks while investing in Mutual Funds.


Absolute Risk vs. Relative Risk


There is a difference in what Mutual Funds consider as their risk, and what investors consider as their “absolute” risk. For Mutual Funds risk is always relative to their benchmark, peers or average market loss. So, if the market loss is 50% and a Mutual Fund underperforms by 40%, its managers are still happy because the Mutual Fund has still performed well “relative to the market”.


The investor in this Mutual Fund, however, might lose sleep over such a loss in his investment. For him the investment is an “absolute risk”. Managing “absolute risk” is always harder than managing relative risk. Because investors tend to be greedy when the market is up and the same investors try to cut their losses when the markets are down, managing and mitigating absolute risk is left to the investor alone.  Therefore, a good part of risk management would remain on the part of the investor and his financial advisor.


Extrapolation, but the past is not the future


Since only historical data on a Mutual Fund is available, it does influence investment decisions. But, history changes. Table 2 is the result of analysis of 3 years past and future performances of top 5 Mutual Funds, in those periods.


Table 2: Top 5 Funds Analysis



Not only did these top rankers come down the ranks, some went below Industry Average.  A long term evaluation (Table3) was done assuming these best performing funds were held till December 2015.Once again we observed diminished returns, and therefore past performance should not be used as the sole criteria for selecting funds for the medium or long term.


Table 3: Top 5 Funds Long-Term Analysis



Investment decisions based solely on past performance will not necessarily yield the gains expected in the medium or long term.


Investing at the right time: Investing at the right time, irrespective of the top performers for a given period is the right strategy. For funds selected at the peak of the market in January 2008, the industry average performance is a dismal 6% p.a. up to December 2015 (as seen in Table 4).


Table 4: MF Industry Average Return



The Solutions:


Given that the market fluctuates, one of the main reasons for poor performance is the “Survival Instinct”, and looking for quick returns, which are primarily ingrained behavioural biases. (To further understand behavioural biases in the investment process, take a look at our video (http://multi-act.com/origin-of-behavioural-biases/).)


Looking at the long term objectives


A value based asset allocation focused on absolute return and absolute risk management over a period  with a risk-reward view will help keep out the jitters influenced by the din in the market.


Useful valuation metrics are in the public domain and essential to develop a simple asset allocation. Also, analysis is possible at the individual Mutual Fund level focussing on the quality of business, i.e. high return on capital employed, good cash flow generation and low leverage, the portfolio holds.


Closed end structures / SIP / ELSS


Since entry and exit times are crucial and giving in to behavioural biases is ideally avoided, a closed end structure focussed on long term ROI should be promoted. Though lock in periods are not commonly favoured, a prudent lock-in period that assures the investor of tangible gains eventual in line with the overall market protect the investor and the fund manager (see chart below).


ELSS (Equity Linked Savings Scheme), with a 3 year lock in provides a better IRR than one based only on net inflows into an Equity MF. SIP (Systematic Investment Plan) as in the example below, with a monthly investment in the NIFTY does perform, while absolute risk management and asset allocation is not in an individual’s hands, therefore safer.


Chart 2: IRR of Investment Structures



Important Mutual Fund Practices


Since empirical data has been proved to be no assurance of future performance, the quality of businesses, a lower number of companies, and a lower rate of turnover of these stocks within the portfolio are of paramount importance in assuring gains, again over a period. Stronger companies are traded lesser since they have inherent strength despite market fluctuations, and a lower turnover reflects confidence in the portfolio.


Conclusion


Investors need to evaluate the Mutual Fund, the quality of companies invested in and if the fund manager has a long term view of the portfolio and not just past performance. Given these, the investor is sure to invest for a longer period and realize the gains that Mutual Funds have as an asset class.


Notes:

  • http://www.dalbar.com/Portals/dalbar/cache/News/PressReleases/QAIB%202016%20Press%20Release%20v1.pdf
  • https://www.hubbis.com/articles-content/5078/articles/Mind+the+(behaviour)+gap
  • http://www.businessinsider.in/Fidelity-Investments-Did-A-Study-On-Which-Client-Accounts-Did-Best-And-What-They-Found-Was-Hilarious/articleshow/41738344.cms -




About Multi-Act Equity Consultancy

Multi-Act is a rare unbiased, independent boutique house. It offers international equity research, consulting/advisory & portfolio management services to large business families, UHNIs, investment managers and intermediaries around the globe. Multi-Act can be accessed at http://multi-act.com.


For more information please write in to editor@indianotes.com


Disclaimer: The author has taken due care and caution to compile and analyse the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. Neither the author nor IndiaNotes.com accept any liability whatsoever arising from the use of any of the above contents.