There is a lot of hype that mutual funds earn a lot of money. It is only hype. In reality they do not. In fact roughly half of all mutual funds (equity and debt, and index funds included) earn less than 8 % p.a.
The Pressure on the Investment Manager to Perform
The hype leads to a lot of pressure on the fund manager or investment officer of the mutual funds, who actually decide where and how much to invest. The pressure can get quite stifling. As salespersons we know what the pressure of target is. It is no different for the investment manager. In fact the pressure may be more. Very often the investment manager and his team of analysts have to take split second decisions on whether to invest or not and how much. This on-the-job pressure is a lot.
Mutual Funds and Comparable Indices
For every mutual fund in existence, there is a comparable index. An index comprises of a basket of shares or debt instruments that have some similarities. A fund that has the same similarities as that of an index are linked. The fund manager or investment manager tires hard to earn more on the fund he or she is managing as compared to the index returns.
Suppose a fund comprises of shares that are mid-cap shares. There is an index for mid-cap shares.
Suppose a fund comprises of shares of the top 200 companies in the stock market, then there is an index that is called “Top 200”.
Similarly there are many other indices. Each fund can be linked to the nearest comparable index available or, if not available, an index can be created for a fund.
An example of a calculation
Suppose an index was originally 100 and has grown to 110. The index has grown by 10 %. Beating the index means the fund value or the NAV should grow at more than 10 %. The more the NAV grows more than 10 % the more successful the investment manager is.
Investment Manager’s Objective: Beat the Index
Beating the index is the operating religion for investment managers. Every fund manager has an objective to “beat the index”. This means that every fund manager or investment manager, wants to achieve a performance for his or her fund that is better than the related index. So, a fund manager of a mid-cap fund, for example, will try his or her level best to earn a return more than the return earned by the Mid Cap Index.
Beating the index essentially means taking more investment risks
To achieve this the investment manager takes many risks. If the investment manager did not take extra risks, there would be no way to beat the index. The index itself is volatile and represents risks. Beating the index requires the investment manager to take more risks than what is represented by the index. An investment manager in a mutual fund who achieves “beating the index” is eligible for handsome bonuses and incentives, which are otherwise not available.
The Investment Manager has no option
In order to achieve the higher return the investment manager has to take extraordinary risks. Suppose in a debt fund, the investment manager is investing in AAA rated securities of companies, the earnings of the fund and the growth of NAV would be more or less what other mutual fund investment managers achieve. May be it would be more or less what an individual investor can achieve on his or her own without having to subscribe to a mutual fund. So why invest in a mutual fund? How does one investment manager differ from other investment managers? It is by taking more risks and hope that all will be fine.
An Example of Unnecessary Risk-taking in Debt Funds
In a debt fund for example, the smart investment manager invests in lower rated company debt. A lower rated company debt means a higher rate of interest. (Not that the higher rate is paid by the company, but there is always hope). For example in the recent Franklin Templeton fiasco, the Chief Investment Officer invested in companies such as UP Power Corporation which promised 10.15 %, Coastal Gujarat Power which promised 9.9 %, and so on. Companies no sensible investor will put his or her hard earned money.
Why do companies offer a higher interest rate?
A question to always ask is: Why should UP Power or Coastal Gujarat give a higher rate of interest than what is normally paid in the market? They offer a higher rate of interest because the risk of investing in those companies is higher than in other companies. It is a trade off. Investors are asked to purchase more risk for a higher expected rate of return. In investments, investors are asked to trade a higher risk for a higher expected rate of return. Higher the risk, higher the expected rate of return.
Implications to the mutual fund investor
What is the implication to the investor, for example in the case Franklin Templeton? The potential risk is that the company mentioned, will not pay the interest when due or will not repay principal when due, or both. In addition, Franklin also carries a liquidity risk on these investments. That is to say, if Franklin wants to sell the debt in the market, so that money is available to pay unit holders who may want their money back, Franklin will find it difficult to find buyers. Not finding buyers results in worthless debt paper, since it cannot be traded. When the companies where Franklin has invested money, actually default, the mutual fund investor will find his or her NAV to be negative.
Knowing all these risks, investment managers yet invest in such debt.
Example of Unnecessary Risk-taking in Equity Funds
Let us take the example of an equity fund. In order to beat the index, fund managers invest money in shares that are in the category of small cap or mid cap. That is in companies that are not worth much on the stock exchange. The theory on this is that a share worth Rs. 10 in the market (i.e. a small cap share) is more likely to double and reach Rs. 20, as compared to a share that is priced at say, Rs. 1000 (a large cap share). There are lesser chances for Rs. 1000 to reach Rs. 2000. This is a belief and does not carry much proof.
So, an investment manager who believes so and invests say Rs. 1 crore in the Rs. 10 share, hopes to get a 100 % return when the price touches Rs. 20. If the price does touch Rs. 20, the Rs. 1 crore fund value now stands at Rs. 2 crores. This bonanza will get the returns on the mutual fund to beat the index.
What is the truth?
But do investment managers actually earn this? Do they actually beat the index? Do they actually beat the market? This is easier said than done. As the saying goes: You can fool some of the people all the time, but you cannot fool all the people all the time. Similarly in trying to beat the index: You might beat the index in one or two years, soon the index will be beating (literally) the investment manager the rest of the time!
The financial markets have yet to see an investor (whether professional or layman) who has consistently beaten the market. Not even Warren Buffet or George Soros. Before the 2008 share market crash Warren Buffet had moved a significant part of his investments to Chinese companies. The 2008 crash affected Warren Buffet as much as it did others. His intention to beat the market failed.
The CIO of Templeton also failed
Take the case of Franklin Templeton. For a few years the Chief Investment Officer (CIO) made a lot of money for his funds, by investing in lower rated debt of companies. it was reported that he managed to earn 2 to 3 % more than other funds by following this strategy. He beat the market and built a great reputation and earned a fabulous incentive of a few crores of rupees. But now his funds have collapsed. They do not even have money to repay mutual fund investors who are demanding their money back.
There are no free lunches
Every basis point of the expected return rate, on a risky investment, contains a risk of not being able to earn it. The risk manifests itself in a number of unknown and unforeseen ways. In this article we have only seen one part – how the pressure on the investment manager plays out to create losses for the mutual fund investor. There are numerous other ways in which the investment risk plays out. This however is not the subject matter of this article.
Caveat Emptor – Buyers Beware
It is therefore important to remember that promises to get higher return indicates that the investment inherently contains a higher risk. Also it is important to remember that if a fund that has earned more money in a particular year, it indicates that, in that particular year the investment manager has taken more than necessary investment risks, and has fortunately succeeded. The chances of the success repeating itself year after year is remote. This is true for even Warren Buffet, leave alone the investment managers of mutual funds.
Life insurance is straight forward
Thank God that in life insurance we do not have to worry about all these complications. Complications which the investment manager in a mutual and has no control on; complications which the financial advisor does not even comprehend but finds the courage to confidently sell, and the customer who innocently believes the confident financial advisor. For the customer, ignorance is financial loss. For others – the investment manager and the financial advisors – it is a financial gain.
As life insurance sales persons we,
Sell Risks Not Returns
Returns are Uncertain, Risks are Certain