This is my 5th article on MF Investing. In this part I will talk about things that the mutual funds will tell you and which you need to take it with a pinch of salt.
- We are a process driven fund house – This is the most often used statement by the fund houses in order to sell their schemes. However the problem now is that this is a commentary that is made by most mutual funds. The question is what is a process? A process is a set of procedures by which a fund manager operates. Now the processes that the fund house talks of is essentially telling you that we have a manual which gives the standard operating procedures which need to be followed before making an investment. The reality is that fund management is an art and it is not a science. Two fund managers meeting the same company with the same set of information might have diametrically opposite views on that particular company. One might believe that it is a sell and the other might believe that it is a buy. Have you ever thought of why the stock market operates? The reason is that at all points of time there are people who have different views on the same stock. Trading is happening because one person is selling and the other is buying at the same time. When sellers predominate at a price the price comes down and when buyers are more the price moves up. Never, never buy the pitch of a process driven fund house.
The performance of a scheme can never be taken out from the ability of the fund manager to manage the scheme. Typically in today’s context there are certain large fund houses that have some fund managers who have been around for several years and are known for their abilities. The funds of that fund house tend to be sold on the name of that fund manager. In fund management the performance will depend on the performance of the fund manager and fund manager alone. So does that mean that the pedigree of the fund house is not important? Of course it is important as it gives you the confidence that they will be able to hire the right kind of people to manage your money and if it is an established fund house or a fund house with a strong parentage then it will be there for the long haul.
The CEO’s of several fund houses will talk of public platforms and try to play down the importance a particular fund manager. Please do not believe them.
- The other part of the story is that the performance of fund managers also tends to by cyclical. The reason for this is that most fund managers tend to have a particular style of investments and a certain way of evaluating companies to invest into. For example I am a growth oriented fund manager as it has been my belief that value without growth can remain value for a prolonged period of time. Also there are different styles of managing funds, some fund manager buy a large number of stocks and some have concentrated portfolios. I as a fund manager have always believed in concentrated portfolios. The need for due diligence should be before the investment is made and not afterwards. Over diversification in the end reduces investor returns as some stocks will be doing well and some will not be. But it is not that over diversified funds do not do better than concentrated funds. They can and they will at various points of time. The risk of a concentrated portfolio is that even if one or two stocks go contrary to expectations the performance might not be as per expectations. But, in general over longer periods of times fund managers that have conviction will do better.
- The cyclicality in fund manager performance is very evident in the markets. It is also evident that particular fund managers might do very well when they are handling mid cap funds but do not do well when they are handling large cap funds or vice versa. The difference might lie in their ability to evaluate macro trends properly, which is required for large cap funds and micro analysis which is required for mid cap funds. So then what does the investor do if the fund manager performance will not be consistent? The way to look at it ideally is to so how much better than the average the fund manager does when his style is working and how much downside protection can he build in when his style is not working. Typically this will be clear over one up and one down cycle.
- The one question investors should ask before investing is what the experience of the fund manager is. Over the last few years we have seen a disturbing trend where fund manager with little or no fund management experience are given large sized funds to be managed by Asset Management companies. This is a disturbing trend and investors should be very careful to see the experience of the fund manager. Normally it is seen that the graduation from handling small funds to large sized funds should be gradual, however someone who was handling a fund of Rs 20 Cr cannot suddenly start handling Rs 1000 Crores in a proper and efficient manner.
- The other thing that investors need to remember is that Debt and Equity investing are very different cups of tea. Equity investing is all about taking the right amount of risk and Debt investing is all about avoiding the right amount of risk. As such normally those fund houses will do better that have well defined Head of Equity and Head of Debt and not an all inclusive Chief Investment Officer who lacks skills in one of the two.
- The other challenge that investors face is that most fund houses will come with spreadsheets and try to sell funds to investors that have done well in the immediately preceding period. The scheme will then start getting inflows and suddenly grow in size. At that stage the performance suddenly slips. The reasons for this are very clear. It is easier to outperform with a smaller fund than a large sized funds, some particular picks might have done well for the scheme when it was small & the fund manager does not have the ability to pick out stocks for a larger sized fund. In the recent past there have also been examples where certain mid cap oriented funds have done well by holding a large proportion of illiquid stocks in their portfolios and as the portfolio size increases this is not possible. As a result of this their performances have faltered significantly as the market move has become more broad based and Mid Cap MF’s that had a more value driven approach to investing have done much better.
This brings me to the end of this article. I will talk more on the subject of evaluating mutual funds in the future articles.