There were no mutual funds sixty years ago when I started investing in the stock market, with the help of my friend B K Dalal, when we were both in college. Since then, I have been investing in equity when I had time and money. I was never very impressed with mutual funds, though I have invested in them from time to time to save time. But the American mutual fund industry, with its enormous managerial variety, gave me something to think about, as this Business Standard column of 10 July 2000 shows.
RETHINKING MUTUAL FUNDS
Mutual funds are an excellent way
of spreading risk and avoiding the hassles of direct dealing. The universe of
American mutual funds is much larger than that in India; there are literally
thousands of funds. Kiplinger lists the top 100 mutual fund families –
families, mind you, not mutual funds.
However, the performance of
mutual funds is nothing to write home about. Recently – only recently – Indian
equity funds have outperformed stock market indexes. But that is because the
funds moved more smartly into IT stocks than the stock exchanges changed the
weightings of their indexes. In the 1990s, mutual funds performed worse than
indices; investors got a negative return on the margins they paid to mutual
fund managers. It could be attributed to the abysmal management of the
government financial institutions such as Life Insurance Corporation and Canara
Bank.
But in the US, such comparisons
have been done on a much larger scale and across much larger samples; and here,
indexes have consistently outperformed the average of mutual funds. They
have a good explanation for it. Investment in mutual funds is so large that
taken together, the stocks held by mutual funds cannot perform very differently
from all stocks taken together. Every mutual fund charges a management fee;
insofar as it trades stock, it pays brokers’ fees. These fees must be paid by
the investors in mutual funds. Hence they are bound to do worse than the index.
Brokers’ fees are about 1½ per cent of market value;
brokers’ fees may be another ½ per cent. So all mutual funds together must
yield a couple of per cent less than the market.
Does this mean that one should
not invest in mutual funds? I think one must distinguish here between equity
and debt funds. It is easier to pick debt; it takes genius to mismanage a debt
fund, although investment managers are known to do it. Reflecting this, the
charges of debt funds are lower. And at least till now, it is much easier for
institutional investors to navigate the debt and money markets than it is for
individual investors. Hence it may make sense to invest in debt and money
market funds than directly in the relevant markets.
Equity funds, however, are
another matter. Their poor performance implies that no one should invest in the
average mutual fund. That would not be too bad; even an idiot would have a 50
per cent chance of choosing a better-than-average mutual funds.
But the figures I have seen
suggest that the distribution of returns from mutual funds is skewed: that the
funds that perform better than average are a small minority, and that the
overwhelming majority performs worse than average. If this is true, then an
investor must pick a mutual fund; and that is quite a skilled job. In other
words, picking a mutual fund is no easier than picking the stocks themselves.
So I conclude that someone who has enough money – say, a million Rupees – would
not necessarily worse off if he invested directly than through a mutual fund.
But he must follow the same risk-reducing strategies as mutual funds would –
invest in a minimum ten stocks, and seek balance – between sectors, risk levels
etc.
Since Americans are no less
knowledgeable than I about investing, why do they invest in mutual funds at
all? The answer is partly that investors develop family relationships – with
their banks, insurance companies, pension funds etc – and these financial
institutions sell mutual funds as well.
But a great deal of mutual fund
marketing has to do with branding. Equity fund managers have different styles,
and investors gravitate towards fund managers whose style they like. The bulk
of the money invested in mutual funds is with the big investment institutions
like Fidelity. But the bulk of the mutual funds are funds personally managed by
portfolio managers with an attitude. This is where the American industry
differs from the Indian. Because of SEBI’s conservatism, there are no personal
fund managers independent of financial institutions; in America, on the other
hand, there are thousands of them. While SEBI simply makes it impossible for a
loner to start a mutual fund, SEC makes it easy but then supervises fund
managers closely; every year it fines many, and closes down some.
This intense competition leads to
some quite innovative approaches. My model is OpenFund, a small $30 million
fund from Metamarkets.com. It displays its entire portfolio in real time on its
web site, as well as all its purchases and sales and the profits and losses it
is making every day. Minute-by-minute disclosure? Most mutual funds would be
scared by the thought that their wonderful strategies would be immediately
revealed to their competitors. So most reveal their portfolios once a quarter;
SEC requires them to do so only twice a year. But if an investment manager is good,
and others follow him, that can only add to his success. I think there is a lot
to this full-disclosure fund.
Those who do not reveal their actual trades are going
towards explaining the rationale of their decisions to investors. Thus, Montgomery has recently started a fund – US Select 20 – that invests in no more
than 30 shares at a time. It updates portfolio information once a fortnight.
But it gives investors access at all times to the reasons for selecting and
dropping stocks, gives statistics on the stocks in the portfolio, and if there
are any major changes or news, emails them to the investors.
Robert Loest of IPS Millennium
Fund, another small, personally run fund, follows a highly individualistic
investment strategy, but gives detailed reasons on the web for his decisions.
He takes a biological view of the economy: that its development is marked by
discontinuities, that market share is the index of the success of an economic
organism, and that those companies grow fast that are members of complex
cooperative networks. Loest does not rely on the conventional indices like
return on net worth, but swears by economic value added. He is not a 100 per
cent zealot; he adopts what he calls a barbell strategy. While investing
heavily in complex, cooperative sectors like telecommunications, he also puts a
good deal into high-return conventional industries like utilities. He explains
his investment decisions in detail on his web site.
Thus, because it is easier to
start mutual funds in the US, it is the home of much variety, innovation and
experimentation. After four lean years, the Indian mutual fund industry is
doing well this year. But the Indian equity market is much friendlier to the
individual investor than the US market; unless Indian mutual funds give him
something he cannot get on his own, the personal investor will abandon them
when the market stops rising. If they are to prosper, SEBI needs to be far more
liberal towards the setting up of new mutual funds, and in particular towards
individual portfolio managers. And if it is to encourage them, it must think of
foolproof but unbureaucratic ways of keeping an eye on them and of keeping
fraudsters out of the profession.
