Fund Performance: Fooled by randomness

Avoid style or theme funds and stick to a few diversified funds. As each fund is diversified enough, putting money across several funds does not help you any better in terms of portfolio diversification.

One would think that most fund managers have similar talent; so the differences in their performance would be minimal. After all, all of them have excellent background and are buying similar stocks. I went through one of the popular fund websites and alas, after a random look at some statistics I find that the performance varies hugely. (A much more detailed analysis appears in the next article - Editor)

My suspicion is that many mutual funds could beat the index comfortably over the past 10 years simply because they had less money to manage in the early years and could afford to be different. With the size of funds growing, fund managers would prefer to be conformist, making outperformance more difficult.

These are huge differences and make our fortune dependent on the choice of fund house and the fund manager. For this reason, I am wary when a fund house changes ownership and, like in the recent case of Fidelity Mutual Fund selling to L&T Finance Holdings, the fund manager is not sold. L&T has to find a new fund manager. Taking someone from DBS Cholamandalam AMC (the fund that was acquired by L&T) does not give one any confidence since DBS Chola never managed any sizeable portfolio of equity funds.

For those of you who stay back with the new fund manager, let us hope that he is a good manager and can do better than what Fidelity would have done. The law permits you to withdraw all investments (including SIPs) without suffering any exit-load. So, if we believe that the change of ownership and of the fund manager is not within our comfort zone, we should exit the fund and switch over to something that is more to our liking. 

Almost half the funds have done worse than the indices. This means that these investors would have done better by sticking to index funds or ETFs (exchange traded funds). ETFs have a lower expense ratio than index funds. The other thing to note is that entry and exit points can make a big difference. Much of this timing issue can be mitigated (never fully) by going in for the SIP route. Given the fact that our markets are volatile, we should take advantage of it. I believe that this year, the markets would be in a range between 15,000 and 18,000. When the markets are closer to 15,000, my SIP size should be higher and when the markets are closer to 18,000, the SIP size should be smaller. I will go wrong if the markets go up, way beyond my expectations. Also, if the markets tank below 15,000 and stay there for a considerable period, I could go wrong. The Nikkei index (of Japan) had touched a high of near 40,000 in 1989-90. Today, it is hovering around the 10,000 mark! A decline of 75% over a 22-year period, with high turbulence in between.

In spite of this, I am still a great believer in equities, provided I can get quality stocks at a decent price. This is a high risk strategy as opposed to investing in mutual funds. Either it gives big returns or I lose big time. This depends on individual preferences. I believe that equity money is 100% risk money. So, if I lose all, it does not bother me. It becomes a lesson for me. Coming back to mutual funds, I will just repeat some obvious things. Avoid style or theme funds. Stick to a few diversified funds. Moneylife tracks mutual funds very well and its recommendations have been excellent. And, as I wrote in an earlier piece, each fund is diversified enough. Putting money across several funds does not help you any better in terms of portfolio diversification.

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