In the first three articles I talked about the Mutual Fund industry in brief, the various kinds of schemes and what these schemes stand for. Now I will be talking about what the investor should expect out of their mutual fund investments and why they should not rely on everything that your MF company contact or the distributor is telling you. The reason for this is simple. The livelihood of most of these people is dependent on making you invest or keeping you invested. This might not be suitable for your financial goal in the ultimate analysis.
The one line that most Fund Managers or others who come to sell you MUTUAL Fund schemes will try to sell you is that it is time in the markets that is important and not timing in the markets and if you remain invested over long periods of times you will make strong returns. However in my view this statement is hogwash. Timing in the markets is as important as the time of investment. This does not mean that you keep on putting money and removing it at very short intervals of time. However the markets follow cycles and if the investment is in line with the cycle of investment then the overall lifecycle returns will be stronger. The typical distributor or sales person in a mutual funds will give you long term return picture with the help of spread sheets, however statistics hide more than they reveal. The schemes that will be tried to be sold to you will typically be the schemes that have done well in the immediately preceding period. The important thing for investors to evaluate is that the factors that made those particular funds do well in that time period still exist or the circumstances have changed.
The other important thing that investors need to keep in mind is that the performance of schemes depends on various factors. The two instances where investors allocated their money hugely into thematic funds and then lost out over the last few years have been Infrastructure Funds and PSU Funds. In the bull market of 2003-2007 the economy was doing very well and infrastructure stocks were the favourite of every one. Each and every mutual fund was coming out which infrastructure funds and by giving the example of the funds that had done well were garnering huge money. However whenever a particular sector becomes very fancied and the valuations of the companies in the stock markets become very high it is important to avoid that segment of the market. Spreadsheet analysis cannot take this into account. The broad benchmark that investors can keep is that whenever the returns from a particular theme fund are twice that of the overall market it might be good to book profit in that fund.
Similar was the case of PSU Funds and Mid cap funds. In the case of PSU’s we had a cycle of strong rerating of the PSU’s when the economy was doing well and government interference in operations was coming down. However the reverse has been true over the last three years. In the case of mid caps, which has always been one of my favourite investment themes also there are cycles of underperformance and outperformance. Although a mid cap fund manager can continue to do well even when the overall cycle is not doing well via their stock picking abilities it cannot be true for all mid cap schemes. Now, when do mid caps do well in general. My experience over the last several years of monitoring mid cap stocks has been that mid caps outperform large cap stocks when the interest rates are coming down and as a result of which the economy has started to do better. A higher economic growth and easier cost of funds are the feeders that mid caps require in general. This is the reason why we see that globally where interest rates are low and cost of inputs are low mid caps are continuously outperforming large caps. Even in the case of mid caps if investors keep a discipline they can make strong returns. Even in the case of mid caps if investors see a situation where the mid cap scheme that they have invested into gives a return that is 100% more or twice that of the Nifty or Sensex they should reallocate some money to large cap schemes. The reason for this is statistically proven. If you take any 5 year horizon the top ranked mutual fund scheme will outperform the market index by around 7-8% on an average. If you have already made twice or thrice that of the returns of the index in any one year it makes sense to reduce risk.
The other important thing to take into account is that whenever the media is talking the most about any one thing then in all probability that is overvalued. My experience suggests that very high valuations i.e 40-50x price to earnings ratio, irrespective of the logic never sustains and the valuations will ultimately revert to mean. We have seen this happen in the case of Technology stocks in the year 2000 where everyday the technology stocks would move up by 10% and most stocks were trading at price to earning ratio of 50-100 times. The same thing was visible in the case of capital goods stocks at the end of 2007 where the valuations of most stocks had gone up to levels of 50-60x price to earning ratio and today most of these stocks trade at valuations of 10-15x price to earning ratio.
In general avoid the hot themes and stick to diversified mandates which gives the flexibility to the fund manager to allocate between themes. However it is also important to see whether the FM has been able to do this in the past. Every FM has periods of strong and poor performance however if better periods dominate then that might be the Fund Manager for you.
More about how to invest right in the subsequent articles.