The Funda Of Exiting MF Scheme

The Funda Of Exiting MF Scheme

More than 50 per cent of the equity funds underperform their benchmark indices. Tanay Loya and DSIJ research team identify why certain MFs underperform and provide a list of MF schemes which can be best avoided.

Indian equity markets may not have surprised the die-hard bulls in the market, but it has for sure surprised the average Indian investors and newcomers to the market with its solid performance in 2017 so far. While every time a new record is being set by the key Indian benchmark indices, the concerns start brewing around stretched valuations and the question often raised is whether these valuations are sustainable.Well, the domestic investors in India have overwhelmingly chosen to ignore the concern on valuations and are incrementally choosing to vote for equity as their choice for outperformance over other financial assets. 

While the enthusiasm for equity markets is reasonably understandable given the sound macroeconomic indicators in India and strong liquidity situation in the markets, one of the most interesting aspect to recognise is the preference for mutual funds as an investment vehicle amongst the investing masses in India. Domestic investors, like never before, are preferring mutual funds as an investment vehicle to create wealth for themselves. The conviction on equity as an asset class amongst Indians is on the rise and the investing momentum is pushing themutual fund industry to new highs. A point in case is the record monthly inflows in mutual funds through SIP which reached an all-time high of Rs 5,516 crore in September. The mutual fund industry has collected close to Rs15,700 crore through SIPs during July to September 2017. This reflects an impresive 49 per cent increase in the amount invested in mutual funds when compared to similar period previous year. What is heartening to see is that it is not only the quantum of SIP amount that is scaling new highs but it is also the increase in the number of SIP accounts that is breaking new records each quarter. The number of total SIP accounts increased to 1.66 crore in September 2017, from 1.45 crore in June 2017, thus adding 21 lakh accounts in the quarter alone. 

While there is no doubt on increasing popularity of mutual funds in India, we believe investors should choose mutual funds extremely carefully, especially when looking for an equity-oriented mutual fund scheme. 

It is very easy for an investor to get carried away by the market moods. Generally, it is observed that investors tend to make wrong assumptions oninvestment vehicle such as mutual funds when markets are consistently doing well for a long time. In a bull market scenario, investors do tend to think that MF investing in the long run is risk-free and that investing via SIP in equity MF scheme guarantees capital protection. While none of this is true, investors ought to pay as much attention on underperforming mutual funds as they do to identify a mutual fund that may outperform. 

In the current bull market scenario or, for that matter, in any bull market scenario, it is almost foolhardy to park funds in those MF schemes that fail to beat the pre-defined benchmark indices. The following table might come as a surprise to many investors who believe that equity-oriented mutual funds almost always deliver better returns than the predefined benchmark indices. The data in the table highlights that a very high percentage of mutual funds actually underperformed their pre-defined benchmark indices. 

The percentage of underperformance is highest for the mid and small-capcategory over a one year period; however, the percentage of underperforming funds is highest for the large-cap fund category if we consider a ten-year period. One of the most interesting aspect to note here is that the least amount of underperformance is seen in the Indian ELSS category. 

The sheer percentage of underperformance of mutual funds goes to show the importance of choosing a right mutual fund to invest. At the same time, it will be extremely useful to know the list of mutual funds that one would do better to avoid investing. The battle is half won if one can identify the mutual fund schemes that one should not invest in. The next crucial step is to identify the probable future winners. 

REASONS WHY MUTUAL FUNDS UNDERPERFORM 

It is widely debated that a fund underperforms due to poor stock-picking skills of the fund manager. Also, when it comes to choosing between active versus passive portfolio management, one of the major reasons attributed for underperformance of any mutual fund scheme is higher portfolio management fee. There could be other reasons such as asset bloating, overdiversification and cash-on-hand beyond the two obvious reasons mentioned above explaining why an active mutual fund may underperform its pre-defined benchmark index or Sensex, for that matter. 

Asset bloating: Asset bloating can be a reality when the AUMs of the funds grow too large. Asset bloat takes place when a fund grows so large that it struggles to limit its investments to its best idea stocks. Research done by C. Thomas Howard who is the co-founder, chief investment officer, and director ofresearch at AthenaInvest, suggests that the average number of best idea stocks is not more than 20 for any fund manager. It becomes practically difficult to identify high-quality stocks that meet the fund manager’s original investment criteria. The way MF industry is structured, there is a meaningful incentive pegged to the growth in AUM and the performance of the fund becomes secondary. One should note here that the MFs charge a portfolio management fee that is linked to the total AUM. 

Over-diversification: Overdiversification could be one of the strong reasons behind a fund’s underperformance. While there is no study which comes up with an objective figure on the exact number of stocks required in the portfolio to beat the markets, statistically, for a fund manager to beat Sensex or any predefined index, he or she will have to be overweight on select stocks and select sectors which are expected to do well. It is hard to believe that a fund with more than 50 stocks in the portfolio that has similar sectoral weightages as the benchmark index will be an outperformer. At best, such equity funds will perform in-line with the index performance. In fact, such funds are likely to underperform as these funds will be charging a management fee as well. So, for a fund to outperform, the fund manager will have to not only be overweight on select stocks but might as well will need to be radically overweight on few sectors for outperformance. This can happen in a concentrated portfolio, rather than a portfolio with more than 50-60 stocks. Investors need to carefully observe the number of stocks in the portfolio and the sectoral weightages of the portfolio. In case there are more than 60 stocks in the portfolio and the sectoralweightages are similar to that of the benchmark index, one should avoid investing in such a fund. 

Cash-On-Hand: Cash-on-hand is one of the factors that investors should look at carefully. The chances of a fund with higher cash-on-hand underperforming is higher when compared to a fund that has less cash-on-hand. In bull marketscenario, the underperformance is even more likely for funds with higher cash-on-hand. For example, let us say an investor has parked Rs100,000 in an equity fund. The fund manager of this fund may be holding 10 per cent of the total AUM in cash. This essentially means that only Rs90,000 is working for the investor and the balance of Rs10,000 is parked in liquid instruments that are expected to generate lesser returns. 

Wide diversification is only required whenWide diversification is only required when investors do not understand what they are doing. Warren Buffett investors do not understand what they are doing. Warren Buffett

Fund managers have a tendency to keep some portion of the fund’s assets in cash for the normal business of redemption of units. At times, a fund manager may hoard cash looking for buying opportunities, thinking that the markets may dip further. On an average, we have seen that mutual fund schemes in India are holding on to cash in the range of 5 per cent to 10 per cent, which could lead to the underperformance of the fund and should be looked at carefully. 

CONCLUSION:- 

There is no doubt about the interest generated among the investing public in India in equity mutual funds. It does look like the markets will scale new highs and the AUM growth for the MF industry will show an uptrend. MF investing is getting popular amongst investors like never before. 

While mutual fund investing can be a rewarding experience if the funds are chosen carefully and correctly, investors need to understand that there are more funds underperforming the benchmark indices than there are funds that are outperforming the benchmark indices. Investors looking at mutual funds for investments need to avoid the underperforming funds, as getting stuck up in an underperforming fund involves a huge opportunity cost in a bull market scenario that we are in right now. 

An equity fund may underperform its benchmark due to various reasons such as poor stock selection, higher management fees, asset bloating, over-diversification and higher cash-on-hand. Investor have to look at all these aspects carefully while selecting a mutual fund that is right to invest in. While looking for investing opportunities in mutual funds, it will be extremely handy for investors to know well in advance which funds are to be avoided. Avoiding investing in wrong equity mutual fund schemes is as advantageous as choosing the right equity mutual fund to invest in. 

METHODOLOGY :- For the purpose of selecting equity-oriented mutual fund schemes that one should avoid investing in at this point of time, we have studied the holdings of each and every equity-oriented mutual fund scheme. Looking at the prospects of the holdings of the mutual fund scheme, we have come up with a proprietary MF forecasting model which helps us understand which fund is likely to underperform or outperform the benchmark index. The MF schemes highlighted in the table are the one that an investor should avoid investing in at this point of time and exit if already invested. Do note the underperforming listed funds may churn its portfolio and hence may bounce back on their rating in future. To keep a track stay tuned to DSIJ.