Eye Opener on Mutual Funds

Kamlesh Uttam

2013

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EYE OPENER on MUTUAL FUNDS

Dear Fellow Investors, There are certain truths about the mutual fund industry which very few people are aware off. Even I think they are knowingly never discussed by mutual fund industry people in public because their own interests will be harmed, be it the fund managers or marketing people or distributors. 1. By rule, mutual funds have to stay invested fully at all times even when another Lehman Brothers kind of crash occurs. They cannot even hedge (i.e., protect) their cash positions through derivative tools (i.e., futures & options). The only options available are to (a) partially cash out or (b) just stay back and watch helplessly mutual funds NAV going down and investors losing money!! 2. High AMC (Asset Management Company) Fee: Every mutual fund house, every year (whether bull market or bear market) charges an asset management fee which is charged even if your fund loses money. Example - HDFC Top200 Expense Ratio is - (a) 1.75 to 2.5% on Daily Net Assets. (b) A charge of 20 bps (i.e., 0.2%) on the daily net assets plus a proportionate charge in respect of sales beyond T-15 cities subject to a maximum of 30 bps on daily net assets. (c) Service Tax on Investment Management Fees. For NIFTY BeES expense ratio is 0.5% only and it gives dividend also. Any mutual fund will not be able to beat your NIFTY50 ETF Systematic Investment Plan (SIP) just because of their high fees i.e., 1.75 to 2.5%+ annually. This much percentage plays a big role on wealth creation by compounding. Do such a sample calculation on any online SIP calculator and see for yourself the difference of 2.5% on your final sum.

3. Mutual funds more or less copy benchmark indices only and mostly do value buying, i.e., they buy into stocks which are underpriced/cheap, i.e., low Price to Earnings (PE) ratios. Now, when PEs have crossed unsustainable levels of >25 for NIFTY, as I have shown in the Figure-1, have you ever heard of any mutual fund advising their clients to exit partially or fully? No! Never!! as it would hurt their annual fee. Larger the size of the mutual fund more fees hence more bonuses, expensive vacations, etc. Unfortunately, they would even aggressively recommend you to buy more & hold. 4. The fund manager is only required to outperform a "benchmark" index of stocks to be able to keep his job rather than to make a profit for the mutual fund, so even if the index or the benchmark loses say 70% of NAV and the fund manager only loses 67%, he gets paid bonus/promoted even though the clients have lost 67% of their money because of the decreasing mutual fund NAV (Net Asset Value) in a bear market.

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5. Imagine a situation wherein suppose NIFTY is at 6000, your mutual funds NAV is at ~100 and a 5 year bear market takes market down to 3000, NAV of MF should go to ~50. No!, in this case AMC fee at ~2.5% annually would bring down the NAV to 44. Now if NIFTY again revisits 6000 after 5 years of bear market plus bull run of 10 more years your NAV would be around 69 only (88 minus AMC fee of 2.5% per year), which is way less than 100 even after staying invested for 15 years!!!(Markets generally take thrice more years to go UP than to go DOWN). Moreover, if the bear market lasts for 15 years, 95% of the mutual funds will go out of business due to reduced fund value and hence insufficient AMC fees!! A Fact: As of today, 24th Mar 2013, there are only 3 mutual funds in India which are beating the benchmark NIFTY50 out of 500+ mutual funds and that too marginally (Quoting Mr. Ajit Dayal, Chairman Quantum MF, on CNBC Awaaz). Why? Reasons can be any or many but the fact will remain the same. Personal Experience: I purchased an ELSS - SBI Magnum Taxgain (Growth) on 26th December 2008 when Sensex was at 9000 levels, NAV of this fund was 31, now when Sensex is at 18600, NAV of the fund is just 59. Fund is underperforming the Sensex by 8% after 4 years of investment. So, when there are SIP facilities available in ETFs like NIFTYBeES then as per my conclusion this is the best option to exercise for long term wealth creation through passive investing!! Comparative Study between ETFs and Mutual Funds Table-1 (Screen shot of NSE document on ETFs)

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WEALTH CREATION THROUGH NIFTY BeES Figure-1

FREQUENCY of PE Ratio Distribution Table-2

Above table illustrates that very low and very high PEs are unsustainable for long. THUMB RULES 1. Double your SIP amount when PE ratio goes below 15. 2. Halve your SIP amount when PE ratio goes above 25. Note: Above thumb rules when applied mercilessly (just by buying SIP) will increase your returns from 16% to 20%+(better than any mutual fund in the market).

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POWER of COMPOUNDING Table-3

VALUE POINTS: 1. Equity markets will always go up in the long run - Reasons (a) Civilization will only go up, (b) People will have babies, new products and profitable companies are bound to come. Inflation added to GDP growth (7% + 5% = 12%) will ultimately be factored in the markets in the long run. 2. NIFTY50 index keeps on replacing poor companies with the strongest & best 50 companies. This mechanism is supportive to lift NIFTY50. 3. High expense cost of mutual funds will not be hampering growth of your money in case of ETFs like NIFTYBeES (Calculations are without factoring in MF entry load/exit load/fines). 4. There always come bull markets in between the 20+ year period with which markets reach to such levels from where they never return back. 5. Try to exit your investment through SWP (Systematic Withdrawal Plan) only. 6. 'Long Term' here means wealth creation for your next generation/ your retirement needs, i.e., 20+ years horizon. ------------------------------------------------------------------------------------------------------Share this with all your MF investor friends; this awareness will certainly help them!! Further queries are welcome at uttamsmethodofselling@gmail.com. Happy Investing! Kamlesh Uttam
Trader, Mentor, RE Investor Alumni, IIT Kharagpur, India

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