Mutual Funds – Way to Create Wealth
CA. (Dr.) Aman Chugh
The author is a member of the Institute. He can be reached at eboard@icai.in.
Mutual funds as investment vehicle are gaining popularity as an alternative mechanism to invest in capital market. The mutual fund industry is growing at a stupendous pace with assets under management reaching ₹ 32.38 trillion crore as on April 30, 2021. In last ten years there has been more than four fold increase in the assets under management that stood at ₹ 7.85 trillion as on April 30, 2011. It is becoming an acceptable way to enter the equity markets that are considered to be risky by many. Major advantage of mutual funds include advanced portfolio management and risk mitigation. Technology has also made the investment procedure convenient. fair pricing.
Mutual fund is a mechanism for collecting money from the investors and issue units in accordance with amount of money invested. Mutual fund managers invest on behalf of original investors in securities in accordance with the purpose of the fund that are disclosed in offer document. Investments are spread over a wide variety of industries and sectors such that risk is diversified and return optimized.
After the pandemic last year, the stocks markets plummeted for some time but to recover soon thereafter. With the recovery, the interest in the markets also revived. A record number of people taking to direct investing in the last one year, let us try to discuss and comprehend the one instrument that has been heavily advertised in the Indian markets for years now and that many people believe is the sure shot way to create wealth, investing passively. The catchy tagline - Mutual Funds Sahi Hai, fancied many investors to consider mutual funds. The initiative helped the general public to learn about mutual funds investment and understand the factors to look for when investing in mutual funds.
Examining Return Calculations & Post-2008 Market Realities
Like any investment, mutual funds are also not free from any risks. Let us try to understand how far the tagline is correct and whether there are any challenges associated with the mutual funds. Whenever we are advised or persuaded by a broker or an advisor to invest money or start a SIP in a Mutual Fund for a long time (in order to create a huge wealth using the compounding of returns), the formula presented includes amount invested every month, period in number of months/ years and rate of return to reach a big corpus. It explains how small investment help an investor to reach a big corpus.
The real problem in this methodology is the rate of return. Investors are shown a very rosy picture of high historical returns and told that these returns would also continue in future. But taking a closer look, often we can find the high returns reflect the period when markets grew rapidly. For example, we can see that many time these returns take into account the period starting from before 2003-04 till date (This is because we saw a Multi Year Rally during 2003-04 till 2007-08 in almost several assets classes, increasing valuations multiple times).
Two Fundamental Shifts in Financial Markets Post-2008
Honestly speaking one should measure the performance of any Asset class from 2008 till date since after the Great Financial Crisis of 2008, Financial Markets’ dynamics have changed drastically in two ways:
- Not all Asset classes have performed continuously at all times after 2008.
- Within each specific asset class, not all types of instruments have performed well at the same time after 2008.
Particularly, let us understand with the example of “Equity based Mutual Funds.” There are ample examples to demonstrate that many well known stocks did not move for years, or moved in well defined phases. When underlying equities are not continuously performing well, how can the Mutual Fund that has invested in them, perform well? Same goes for Debt and Hybrid Mutual Funds. Therefore, if we look at the performances of Mutual Funds in the last 3, 5 or 7 years, the results are not very encouraging (Except that again in 2020 due to Covid crises, the massive liquidity pumping by all economies has led to massive rally but such boost is also capable of bringing the jolts in the times to come. One should always remember, “past performance is not indicative of future returns.”
In fact, as per independent research, it has been observed that even in the last one year (wherein Markets have given a spectacular rally due to massive liquidity pumping), many leading “Large Cap Mutual Funds” have either failed to outperform the broad Market Indices or barely outperformed them; while some of the theme based or sector specific funds have only performed well for a specific time period (such as Pharma sector funds in the first half of 2020 and now commodity based ones).
Factors that Directly and Indirectly Reduce Mutual Fund Returns
Now that we understand this aspect, let us take a look at some other factors that reduce our returns directly/ indirectly if we choose to invest in Mutual Funds:
1. Loss of Portfolio Flexibility
Investing in Mutual Funds takes away our liberty to further add or exit from the underlying stocks as per changing circumstances.
2. Drag of Loads and Expense Ratios
Our Gross Returns get reduced due to Entry Load, Expense Ratio and if applicable, an exit Load.
3. Deprivation of Corporate Action Benefits
We are also deprived of bonus issues, rights issues and buyback offers announced by the companies.
4. Additional Brokerage Costs
If we invest through a Broker, we also incur brokerage, further reducing our return, even if we don’t earn a decent profit on our investment.
Up until here, it is safe to say that various on-screen and social media experts as well as our brokers have been recommending Mutual Funds as an ideal investment vehicle to create wealth in the long term, on some occasions for their own interests.
Investing in Knowledge & Direct Investment Alternatives
The best way to build a portfolio and create wealth in today’s world is to invest in knowledge first. People with interest and knowledge can directly invest in some the stocks and debt instruments. Some of the investors can proceed passively and invest in the common shares held by some top Mutual Funds as that would provide returns while also giving greater freedom of entry and exit. Thus in the overall portfolio a proportion of investment must include shares of some leading companies. Remember that long term investments are considered better as they smoothen the fluctuations in the market.
Still, there might be some people who are of the opinion that they cannot devote much time to learn the market dynamics and hence, cannot actively manage their money. In such cases, mutual funds are good solutions. For those people, even if investing through mutual funds, one needs to periodically review the performance and churn the Mutual Fund investments rather than sticking with the same fund for an indefinite period.
It is also important to know that some agents persuade investors to unnecessarily churn the portfolios, may be to earn the commission that they receive. It is worth noting that mutual funds can be subscribed directly without any intermediary. An investor can visit website of the mutual fund to directly subscribe to the mutual fund.
Key Strategic Principles to Ponder Upon
Hence we need to ponder upon the following important points:
Recognise Changing Market Dynamics
To reiterate, it is crucial to understand that Financial markets today do not have the same dynamics and do not behave the same way they used to do 10, 15 or 20 years ago. Now, asset classes and various instruments go in and out of trend every now and then.
Be Long-Term in the Market, Not Stuck in the Same Asset Class
In order to create wealth, it is necessary to understand and follow the changing dynamics and adjust our investment strategies and decisions accordingly. Periodic reviews of our portfolio have become a necessity. Be in the market for “long term” but not in the same asset class or the same instruments within an asset class.
Underlying Asset Volatility Precludes Guaranteed Returns
Since, underlying Equity Shares or Money Market Instruments or Longer Term Debt Instruments such as Bonds cannot be continuously performing in terms of uniform risk and return all the time, Mutual Funds that put our money into those instruments also cannot be guaranteed to perform continuously.
Prudent Churning & Duration Balance
Therefore, even if one has to invest in the market through mutual funds, investments should be churned from time to time, booking profits when the opportunity comes and shifting to better alternatives. However, a delicate balance should be maintained as some of the industries are cyclical in nature and accordingly the returns may fluctuate, for example in sector specific mutual funds. Investments should be for sufficiently long duration.
Role and Perspective of Chartered Accountants
Chartered accountants clearly understand the nuances of the mutual funds. While investing we must have a mix of different asset classes to balance risk and rewards. A lopsided strategy will only increase the risk that should be avoided. Investment in other avenues must not be ignored. Members of accounting profession, with their deep-rooted knowledge of finance may like to invest directly in stocks and debt instruments rather than investing indirectly through mutual funds.
At the same time while acting as investment consultants mutual funds can be suggested to clients based on the profile of the investors. It would be easier to convince a risk averse investor to consider mutual fund when compared to shares.