Diversification might sound like a risk-management cliche. However, some cliches earn their due. Diversifying one’s investment portfolio is not just imperative, but also requires a great deal of skill and time. A couple of stocks cherry-picked by you shouldn’t dictate your life savings, right? This is why there are a few quick and easy diversification shortcuts in the market. Namely, investments like mutual funds, index funds, and exchange-traded funds.
Unlike bonds, single stocks, or other investments, mutual funds, index funds, and exchange-traded funds provide instant diversification and fall into a low-risk category. That’s simply because when you invest in either of these instruments, you are actually investing in a basket of diverse stocks, and the underperformance of any one stock is compensated for by the rest of the stocks in the basket. Essentially, you place your trust in the curation of these instruments.
Yet, they aren’t all the same. And if instant diversification is the value you seek in your instruments, understanding the nuanced differences between them will help you pick the one most suited to your goals.
Mutual funds is clearly the most popular of the three. The Assets Under Management (AUM) of the Indian Mutual Funds Industry has grown from ₹ 7.28 trillion in 2011 to ₹35.32 trillion in 2021. That’s more than a 4½ fold increase in 10 years! If advertisements are anything to go by, mutual funds sahi hai!
Why then do we argue otherwise?
Why Mutual funds may not be the right fit for you
Try googling why you should not invest in mutual funds, and you’ll find that most of the top ten results on page one indicate that mutual funds are a great investment option. Almost giving you the impression that your investment is free of risk, without quite stating it. Risk toh life me bhi hai.
Yet, many risk-averse investors who always play safe with their securities tend to avoid mutual funds. In fact, according to a recent livemint article, the AMFI data suggests that investors are selling their mutual funds investments in a big way. A bit surprising, isn’t it? Wonder why? Read on.
The passive approach beats the active one
Mutual fund investments are almost always actively managed. Meaning, humans control the funds in the hope of outpacing market indices. Other investments like index funds are managed passively, i.e. with minimal human involvement. Funds like the S&P 500 have a goal of delivering returns that match their benchmark. Managers are simply responsible for ensuring that investments in the fund match the underlying index.
A human staying on top of things actively on your behalf may sound like a good idea at first. But the evidence does not bear that out. Compared to passively managed funds, most actively managed funds underperform even before accounting for fees and other often invisible costs.
Sales charges and high expense ratios
A fund’s expense ratios and sales charges can sometimes spring a surprise if you’re not paying attention to them. Expense ratio refers to the total fraction of the assets in a stock or asset fund that goes into administration, management, advertisement, and all other expenses. Note that a fund with an expense ratio of more than 1.50% is at the high end of the spectrum. And even a marginal difference in the expense ratio can have a huge impact on your returns in the long run, as the amount gets compounded year on year for the duration of your investment.
If you haven’t tired of the buzz of mutual funds in the media, you must realize that marketing, advertising, sales, and distribution budgets too get factored into the expense ratio burden you eventually bear. The irony is if you’ve heard more about a particular MF in the media, chances are, they are paying more to reach your eyeballs and therefore charging you more in terms of the expense ratio to budget for the ad spend.
Tax Inefficiency
The tax efficiency of your mutual fund is determined by several factors including the frequency of trades, the duration of each investment in the basket, and the types of distributions. None of which are in your control once you’ve signed up. This means, your security holdings change throughout the year. And therefore, profit and losses in the fund are typically uncontrollable tax events. Once you are locked in for a period of say, five years, there isn’t much you can do in terms of tax adjustments in between.
Poor Trade Execution
Mutual funds trades are executed once a day after the market closes. When the smallest unit of time is a day, trading strategies are severely limited, especially the ones requiring short investment horizons and day trading. Therefore, the marginal value of fluctuations within the trading hours can not be captured.
Investor Psychology
Let’s take a look at the cognitive behaviour of investors.
A study of investor psychology aims to understand how investors feel about the markets and how it may influence their investment decisions. An analysis of over 30,000 households in mutual funds accounts at a large U.S. discount broker reveals a counterintuitive but significant observation.
It states investors are more inclined to sell funds with solid past performance than to sell funds that have performed poorly. As a result, it is difficult for an investor to exit a low-performing fund. Counterintuitive? Yes. Investing is a high-stakes landscape where cognitive biases could prove quite costly.
So, are mutual funds a bad investment?
No. That isn’t the whole point of the argument. Mutual funds do provide the positive risk-benefit of instant diversification. True, and that is certainly valuable. However, is that the only ‘safe’ option you have? No, again. Understanding and being aware of the pluses and minuses of all your instant diversification investment options is Step One to determining the right fit for you.
The current trends indicate that innovations in the securities markets promise a few interesting alternatives. If you are interested in investing across a broad stock index, ETFs have several key benefits. Whatever you choose, keep fees low and seek out the funds you want to hold for the long run.
Isn’t that a thumb rule for any investment?
Want to know more about various investments and strategies? We are here to help you.
