Mutual funds - not so good.

It is difficult to figure out why small investors should put their money in mutual funds. But millions of them across the world, including in India, do. The logic for such investing is simple and appealing. I, the lay investor, have neither the resources nor the ability to track individual equities. So, I will put my savings in the hands of experts who will do the job for me, at a price.


(For the purpose of this discussion, we will stick to investment in equity-focused schemes which are popular with retail investors, and not go into debt- and sector-focused schemes in which firms and experts dabble.)

Trusting the expert is fine but how do you pick your expert — the particular scheme of a fund in which to put some or most of your savings? In India, there are no more than 500 actively traded shares of firms of any consequence. There are mid- and small-cap firms, with and without promise, not to speak of technology startups, the successful among which can make an aggressive investor a millionaire. But they are not for the risk-averse small investor. All she wants is returns which are several percentage points higher than what bank fixed deposits will pay — and this is important — the ups and downs averaging over a period.

There are now over 3,000 schemes, five times the number of established, visible companies. Well-known firms are touchy-feely things. You see their presence — factories, offices, employees, products — everywhere. But a fund house in comparison is a faceless post box, or a few floors in a financial sector office block.

A mutual fund buff will tell you that a little bit of research will enable you to select a few well-performing schemes and you are guided in this by the extensive disclosures and mountains of research and rankings that swamp the financial media. But if you have the gumption to research mutual funds, then you can research stocks too, and good ones are not cheap (nothing good is) but easy to pick. Most small investors have till now chosen schemes recommended by a commission-earning agent or a friendly adviser at your friendly bank who herself and her bank earned a fee on selling the product to you. Significantly, mutual fund sales have plummeted ever since Sebi, the capital market regulator, stopped charging the investor a fee for the selling agent.

After the quite unscientific selection on the basis of advice from commission-earning agents, the small investor’s problem is not over. How long does he stick to a scheme? Is there a case for churning your investment once in a while, not too often though, to take advantage of new, attractive options, which again agents have been more than happy to recommend? If your investment is doing well, then the urge to churn is low.

But what if it is not? And, what if the fund management professional who was a bit of an industry acknowledged whiz-kid has moved? Typically, fund management professionals change more often than company managements. The latter happens when there is a succession or a merger or acquisition deal involving the company. Even otherwise, a CEO change in a firm is less discontinuous for it than a fund manager change in a mutual fund.

Now let’s come to the returns that fund schemes bring. All funds taken together seldom outperform the market. If they did, the choice would be easy: invest in a fund of index funds.

Here again, there is a catch. An index fund is not really on autopilot. Stocks that make up an index change over time. By the time a stock drops out of an index, interest and activity in it and its valuation have usually waned. After the exit, the stock can go through the same process a bit more. A well-managed index fund will go light on a stock before it is dropped from the index.

The cardinal argument in favour of mutual fund schemes is that there are any number of them which outperform the market. They do. But it is more difficult to pick them than to pick a few good stocks. An additional plus point in favour of picking a scheme is that in the process you select an entire portfolio, which spreads your risk. If you have to pick your own stocks, then you have to pick several.

The key to sensible investing is to know your own preferences. If you are totally risk averse, go for bank fixed deposits. If you have a longer time frame, six years or more, then go for the public provident fund. If you can stay invested for over six years and agree to take on a small risk, then go for equities.

Make a list of say 20 best-known companies which are considered to be alive and kicking. Make sure that the list has both firms whose products are widely used and popular, like Maruti Suzuki, and firms with a strong physical presence (plants and townships) like Tata Steel and NTPC; don’t end up with over-representation in one sector (too many software shares); then divide up your investment funds into five and make your investment at six-month intervals over a two-year period. Thereafter, forget about it for five years. My sense is that when year seven dawns, your portfolio will have a distinctly better chance of giving you a handsome return than going the mutual fund route.