Should mutual funds be your default go-to equity investment option?

Or in other words, is ‘Mutual Funds Sahi Hai’ really always true?

Okay, I admit that the title goes against conventional beliefs that mass media and TV ads love to parrot daily. So, bear with me for a while to know the other side of the story. Let me tell you what neither the ‘Mutual Funds Sahi Haiโ€™ ad makers nor the AMFI (Association of Mutual Funds in India) will ever tell you.


Skin in the game

Does your mutual fund manager invest a substantial part of his own personal wealth is in his own fund? If a fund manager is investing elsewhere, what does it tell you about his own confidence in his own ability? Here are some examples. Although this report doesn’t tell the investment amount as a % of the manager’s net worth, you can clearly make out that 20-50 lakh must be a minuscule % of the fund manager’s wealth.

This is a clear asymmetry of risk and return. They get to keep the upside in the form of annual bonuses with no equal penalty for the downside. You and you alone get to bear the risk. True skin in the game means one must bear both the upside and downside risks of one’s decisions equally in either case.

Another recent example was the Franklin Templeton fiasco where they invested in junk debt instruments all over the years for the upside without even protecting or thinking about the downside, all in the hope that those investments will keep paying off forever. May be, because they knew they aren’t personally liable when things go wrong! A perfect example of asymmetry of benefits.

As another thumb rule, avoid taking advice from a person unless there is a penalty for them for their own advice. Or in other words, donโ€™t ask anyone what stocks to buy, ask whatโ€™s in his/her portfolio.

Also, mutual fund houses are generally owned by big banks or large corporate houses which install a manager at the helm on a salary. On the contrary, hedge funds, AIFs, RIAs and small boutique funds have an owner-operator at the helm with a substantial part of their own wealth also invested in them. Thatโ€™s true skin in the game. Hence, look for owner-operators.


Liquidity

Whenever a structural macro change happens either in the economy or a permanent change in your specific investment or sector, a huge fund worth hundreds of crores would have a hard time exiting that particular stock quickly. Even if they want to exit and they end up exiting, their own sell volume would be so much that they would make the stock price fall substantially. Same happens while buying. A small company can easily rise 10-15% while a mutual fund is building up its position, hurting the cost of entry and eventually your returns. Ultimately, what this does is force the fund to hold the stock through bad times, hoping the company turns around in a couple of years or so. Again, at the cost of hurting YOUR returns.

But you as a retail investor does not need to bear this at all! The biggest advantage a retail investor managing his own portfolio has is quick entry and exits, without disturbing the stock price at all. Or invest in a small sized fund house if one doesn’t have the time/ability to manage his own money.


Herd investing

“You will never be fired for buying HDFC Bank” is the equity equivalent of “You will never be fired for buying IBM” of the IT industry. It doesnโ€™t matter how that specific company will do for the next 1 year but the mutual fund favourites remain the same. Have a look here what they hold the most.

Why? Imagine you are a fund manager. Would you risk losing your job by going against industry favourites and buying an unknown company which may bomb in future? Or would you rather keep your job safe buying industry favourites, all with the assurance that you know that you wonโ€™t be fired for holding what everyone in town holds in their funds. Even if you go wrong in that investment!


The uncertainty excuse

“It’s a Black Swan Event” is an oft-misused term and remains the biggest cover-all for all kinds of mistakes of the fund manager. Be it a credit crisis, global financial crisis or covid crisis. Macro uncertainties always exist and have existed forever. Uncertainty will always hit you from where you least expect it to. But, it is the job of the fund manager to manage risk and have a plan for all sorts of contingencies.

Every year there is at least one mini crisis and every decade, a mega one. Although no one can predict whatโ€™s going to happen tomorrow, one can surely be prepared for it or react quickly to developing events. Huge allocation to one particular sector/stock, highly correlated investments, ‘buy and hold forever’, not admitting when one is wrong, not limiting losses quickly, not diversifying across asset classes/geographies – are all examples of poor risk management. The fact remains that inferior risk management skills and the inability to prepare and act for every eventuality kills returns. Eventually, they come on TV as talking heads to wash their hands off it, parroting the same ‘uncertainty’ line.


โ€˜We buy for the long termโ€™

Well, the fund manager buys for the long term but he/she would be long gone before long term comes! 20% of American fund manager have tenure of less than 3 years. The ‘hold for the long term’ excuse again rears its ugly head whenever one sees a big drawdown and the fund is unable to protect your capital.


Tonnes of stocks

When one buys a stock he isnโ€™t 100% sure of which way it will go. So, an investor tries to spread his bets and buys 20-25 stocks, making sure they are buying across different sectors also. This is called diversification and this happens across all asset classes irrespective of whether itโ€™s a PE fund, angel fund, debt or listed equity investments. Also, many times, all investments in an asset class move together in case of a broad market or macro event. So, one should diversify across all asset classes like gold, commodities, debt, equities etc.

However, investing in too many companies isnโ€™t helpful at all since all of those stocks are anyway correlated at a level and systematic risk of that asset class takes over in this case. Basically, you don’t get any additional benefit of diversification beyond 25-30 stocks in a portfolio. But, what do mutual funds do? Since they have a problem of big fund size, they are forced to buy 50-100 companies and they end up ‘di-worse-ifying‘ their portfolio in many cases. The result is that most mutual funds are unable to outperform the broad market. So, ask yourself – if you are making the same returns as the index, why are you paying fat fees to the fund manager?

So what should a retail investor do and how should he/she invest? So, in the order of priority, he/she should:

#1. Learn how to invest. You are the best manager of your own wealth
#2. Invest in owner-operators with TRUE skin in the game
#3. Hire a trusted financial advisor
#4. Invest in passive low cost funds that mirror the index. You will do as good as the economy and the broad market does and this isnโ€™t a bad deal for many at all!
#5. Invest in active equity mutual funds ๐Ÿ˜‰


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