Tuesday, October 19, 2010

Mutual Funds - All weather harbour


I met quite a few investors over the last couple of weeks. Clearly, there is discomfort in equities at these levels. Whilst they are not too worried about the growth of the economy, there is a feeling that the markets have run ahead of the fundamentals. There is a reluctance to put additional money in to the broad market and most of the HNI’s I know have been switching out to other avenues. Some are going in to MIP’s (having some comfort in the fact that the schemes generally cap exposure to equities and will keep booking profits in order to do so in a rising market), being happy with the returns. Whilst MIP’s will not deliver chart busting returns, they do generally give better returns than a bank deposit, with tax advantages that mutual funds enjoy. Here, one has to be careful, since just around half a dozen of them have given ten percent or more returns in the last twelve months. You also have some of them delivering sub five percent returns.
Some are shifting to income funds. The general view is that interest rates are close to peaking and will start to correct. The problem with Income funds in India is that these funds need the benefit of timing. Without that element in your favour, the returns are generally pathetic. One year returns on long term debt funds have ranged from SUB ONE PERCENT (!) to around nine percent. Not a very encouraging sign. Here, one has to time the entry and after getting a near double digit return. If you stretch it to three years, about half a dozen have returned near ten percent annualised, with the vast majority being under five percent. Not very encouraging and indicates that even the fixed income fund managers are unable to match bank deposit returns.
From my long term experience I have found that diversified equity funds tend to deliver the best returns if you take a perspective of three years and more. Not every fund in the category, but definitely the top ten. Here I do not find much difference between a mid cap and a large cap. Yes, over a short term period there are divergences, but over a longer term it tends to even out. Even sector funds (with the notable exception of banking sector, which seems to be on a roll now) are no different. So, it is not much use choosing between different types of funds. With almost all funds in any one category having similar or same stocks, diversification does not happen.
To me, the biggest disappointment has been the ELSS category. In the initial days, the thought was that ELSS funds will outperform, because the fund manager will not face redemption pressures and could plan a longer term investment strategy. Alas, churn seems to be a better reward, unless one opines that the fund managers do not think long term. Or is it simply that the ELSS schemes tend to be a small percentage of the overall AUM with fund houses and that they neglect it? Whatever be the reason, the ELSS funds have delivered almost five percent lower annualised returns over three years, as opposed to the diversified funds! The lower returns have virtually nullified the effects of any tax saved on that count. As a long term strategy, it seems best to avoid the ELSS category.
I do not like the Gilt funds category. This is because these schemes are either used by PF’s or institutional investors. More important, with the underlying assets trading in market lots of 5 crores, there is an inbuilt inefficiency. In the old days, the banks used to park money in gilt funds for speculating on the movement of interest rates on the ten year bonds. In 2004, spectacular returns were had, when the interest rates on 10 year paper fell from eight percent to sub five percent. However, if you take a longer term frame (three or five years) the returns are a decent ten to fifteen percent per annum for the three and five year periods respectively. However, the corpus is not large enough to warrant a general endorsement of this category. As a class, it has done better than Income funds. From the safety point of view, I would certainly rank the gilt funds higher. So far, our Income funds have not taken any blows (except in the early years, when one of the AMC’s took it upon itself to bail out the investors by buying a defaulted paper from the fund), the risk remains.
Some of the HNI friends seem to of the view that of the different sector funds, the Infrastructure sector funds are lagging behind and are putting money there. The expectation is that this sector will do well, with real estate stabilising etc etc.,
The lesson I have learnt is that it pays to remain invested for a long term. Churn does not benefit the investor. Perfect timing of every move is not possible. One bad move is all it takes to wipe out a lot of hard work that has been put in. I do believe that the mutual funds have done a decent job in India and for those who do not have the knowhow to do their own homework they offer the best avenue. I would keep away from PMS because of their tax inefficiency.


ArthaNITI said...

Sir, the fact that small & mid-cap fund returns are similar to that of large-cap funds is a pointer to what? Fund manager's tendency to churn portfolios (and hence not stick to their bets long enough?) or the general lack of good quality managements with long-term vision in the mid-cap space? or any other reason - your views please!

Frustrations Amalgamated said...

@ ArthaNITI- Thanks for raising an interesting point.
Mid cap space is very treacherous. In many cases, it is the fund manager who makes and breaks these stocks. One fellow starts accumulating quietly. Then the ‘idea’ is sold to a fund manager. He now starts buying. In the first case, the stocks come from the promoter. In the second case, it comes from the promoter and the first ‘discoverer’. Once there is a run up in prices, both dump. Liquidity vanishes. Unless there is control on the supply of stocks, prices generally trend one way. The other issue, as you rightly point out, is of quality. Out of ten stocks, one may turn in to an average stock. The rest simply vanish or languish. Hence, the mid stock universe does not deliver better returns in aggregate. A single stock or two may become multi baggers. The fund houses rarely have multi baggers, because of market capitalisation reasons. When a co market cap is 20 cr, the max a fund can buy is a crore worth! And he may have a rule that he will not buy stocks with market cap less than 200 or 300 cr. In which case, the price has to multiply ten to fifteen times before he can buy! Hence mid caps are good for individuals and not so great for mutual funds. Hope this explanation makes some sense.