What Fund Managers And Advisors Won’t Tell You

Everybody wants to benefit from growth, movement in interest rates and get the best returns for their surplus funds. In short, everybody wants the best returns for their investments but does not know how to achieve it. The simple answer put forth before a common investor is “mutual funds” as they offer professional fund management with even a small investment amount.

However, do the fund managers and mutual fund advisors and distributors tell you all about your mutual fund investments? Or are there hidden facts they may not state. Read on to know more.

Hidden Fact 1: Expenses Eat into Your Returns

A mutual fund may have a lot of expenses like fund management expenses, loads etc. These may appear to be small but over a long term, say 10 years, they may eat into almost 20 per cent to 40 per cent of your returns. Hence, you are paying high costs for fund management and distribution. And if the fund does not generate “extra return” on your investments, then you are simply paying high costs for sub-optimal performance. 

Hidden Fact 2: Fund NAV is Meaningless

An investor feels that a fund with a lower NAV is cheaper compared to a fund with a higher NAV. This happens because the investor neither understands nor appreciates the difference between price and value. A MF unit in itself has no value – it is “not” an asset like a house property, bond, equity stock, gold etc. It derives the value from the underlying asset which it owns. 

The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units. For example, there are two Funds – A and B. Now, the NAV of Fund A is Rs 10 per unit while the NAV of Fund B is Rs 50 per unit. Does this mean that Fund A is cheaper than Fund B? Not at all. The NAV simply means that Fund A is holding such assets in totality, which when divided by the total number of units results in a NAV of Rs10 and ditto computation for Fund B, which results in NAV of Rs 50. 

If we assume that the portfolio of both these Funds is exactly similar, then a 20 per cent rise in the value of the portfolio will result in a commensurate 20 per cent increase in the value of the NAV of the Funds – Rs 2 in case of Fund A while Rs 10 in case of Fund B. Hence, while investing in MFs don’t look at the price of the NAV but rather the underlying value which is derived from the portfolio of the fund.

Hidden Fact 3: You Can Lose Money in Fixed Income Funds

You may not be told that you can lose money in Fixed Income Funds. Contrary to its name, the income from it is certainly not fixed. There are different types of risks associated with fixed income securities like credit risk, interest rate risk, yield curve risk, basis risk etc. The most common risks which an investor attaches to fixed income investments is credit risk. Having said that, there is one more risk which is as important as credit risk ie  interest rate risk. Few people understand this risk. If you are investing in long duration Income or Gilt Funds than you are at the mercy of interest rates. And interest rate risk is directly associated with the maturity of the security – the higher the maturity, the larger the interest rate risk associated with it.

Hidden Fact 4: Income or Gilt Fund Will be Able to Beat a Normal Debt Product Only if Interest Rates Were to Fall

Income Funds are nothing but interest yielding debt products. But, when someone deducts high fees from the interest rate then substantial fall in income yields. That is what happens with income funds, which are loaded with high fund management expenses. Hence, investing in Income or Gilt Funds is nothing but paying heavily for buying an interest paying security and then hoping to earn capital gains on it.

Hidden Fact 5: Liquid Funds Offer Risk Free Returns

As mentioned earlier, there are different categories of risks while investing in debt funds. A liquid fund may have negligible interest rate risk since it runs a very short maturity, but it certainly has credit risk as it primarily invests in corporate papers. And mind you, for getting 5 to 10 bps of higher return, many times a fund takes unnecessary and avoidable risk of investing in inferior quality of papers. A liquid fund is for parking surplus funds and an investor would not want his capital to be put at risk for getting a few basis points of higher return.
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Hidden Fact 6: Ignore Index Funds

Another common mistake is ignoring a simple low cost index fund in favour of a high cost actively managed fund. And generally nobody encourages or advertises an index fund. Why? The answer is simple – the fund management fees are minimum in an index fund. Remember that it’s very difficult, if not impossible, to beat the stock market indices consistently over a long period of time. If that were not the case, then why over periods of a decade or more, approximately 75 per cent of all “actively” managed stock funds underperform the passively constructed stock indices. 

The fact is that most people have no reason to believe that they can pick winning stocks or time the markets and their success at it would be the same as it would be like throwing darts at the financial pages. I would like to quote Dr. William Bernstein who said “There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know where the market is headed. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know where the market is headed”. Merton Miller, Nobel laureate commented that “If there are 10000 people looking at the stocks and trying to pick winners, one in 10000 is going to score, by chance alone, a great coup, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they are doing something purposeful, but they’re really not”.

Then I would quote Rex Sinquefield “We all know that active management fees are high. Poor performance does not come cheap. You have to pay dearly for it”. Thus, active fund management is nothing but paying heavy fees for underperforming the passive indices. Therefore, the conclusion being that there is no reason for you or anybody else to believe that they can pick winning stocks or time the markets. Hence, the best solution for any equity investor is to stock into low cost passively managed index funds because year after year they would beat atleast 75 per cent of the actively managed funds and over the longer term in most probabilities beat almost all the funds.

Hidden Fact 7: SIP is the Best Route to Investing

SIP is certainly safe for mutual funds and distributors because they get committed money continuously for a long term on which they can earn fees and commissions. It is also safe for the financial planners to recommend it because if anything goes wrong then they can blame the SIP system. However, for an investor, it is just another method of investing. It has its pros and cons. SIP works the best in a bull market or a volatile but rising market. On the other hand, SIP under-performs in a bear or sideways market.

Hidden Fact 8: Fund Churning is Injurious for Long Term Wealth Creation

Fund churning might be a popular advice by your MF Distributor. Instead of churning your fund, just churn the MF distributor who gave you that advice. Distributors love the churning game – simply because it gives them extra commissions and fees while it gives you extra income tax, expenses and most probably a sub optimal fund. But the worst aspect of trading funds is that it allows the counterproductive emotions of investing to supersede the productive economics of investing. The dream of a perfect plan will never come true if mutual funds are traded as if they were stocks.

Hidden Fact 9: Owning Too Many Funds

The more funds you own, the greater the chance that a truly inspired fund selection will have its success spoiled by another fund that falls on its face. The problem has been called "diworsification," for it leads investors to build a portfolio of funds containing so many individual stocks that it becomes contradictory for the holder. 

Even more counterproductive is the active trading of mutual funds. Typically, an investor today holds funds for but three years, an absurdly inadequate time frame for appraising the results of an investment program that should be inherently long term by nature. What is worse is that the funds may have been ill-selected in the first instance—funds with inflated performance, funds investing in hot market sectors, funds advertised on television, funds that trade actively and relinquish much of their profit to taxes, funds with high costs that didn't seem to matter when their past records looked so good.

Hidden Fact 10: Fancy Funds, Fads and Fantasies

Many new funds and schemes pop up during times of exuberance. These funds are simply smart tactics to collect money from the gullible investors. No sector or theme continuously performs well over a long term. Even worse, a sector fund is generally launched after the sector has already performed well because the fund has to show good past performance to attract fresh investor money. And by applying the “law of averages”, it is likely that the sectors which have already performed well in the past will actually not perform so well in the future. Hence, never fall prey to fund gimmicks and invest in sector or theme based funds.

To conclude, you may not hear everything you should be hearing in regards to your mutual fund investments from the fund managers and advisors. However, reading and thinking between the lines would greatly aid you in recognising the hidden facts. And once the hidden facts come fore to you, don’t pretend to hide behind them. Instead pay heed to them, try to listen to what message it has to offer, learn from them and go on to become a more clever, informed and an articulate mutual fund investor.