There is No Fate But What We Make: Equity Mutual Funds vs. Index based ETF

Sunday, February 08, 2009

Equity Mutual Funds vs. Index based ETF

Ask my grandpa. He thinks of FDs and traditional Insurance policies as the only investment instruments. Looking at the historic data, equity is our best chance of earning inflation beating returns. We can create a better asset allocation plan by having a part of our assets in equity. Exactly what % of their assets should be in equity depends on the risk profile and the time horizon. We will be better off considering equity in addition to the existing FDs and insurance policies.

On the other extreme, many of us invest in individual stocks, either from the open market or through IPOs. Implicit in this kind of investing is our belief that the portfolio we create in this manner will do better than the general market. Otherwise, why will we take the pain & risks of individual stocks (the fact that we don't consciously think of this is a sign that we are being irrational).

Do we ask the question - what are the odds that I would beat the general market in a sustained manner ? How many of us work the numbers and evaluate the performance? After adjusting for taxes, brokerage and other expenses, did we beat the general market ? Most of us would be clueless on how to do this ? The right way to do this is to calculate the portfolio IRR over the extended period. In contrast, the most we do is to cherry pick specific stocks and time periods in an anecdotal manner. Useless bits such as "I bought this stock at X and sold at Y" get bandied about. What is required is the portfolio IRR over the complete time period, adjusted for expenses, taxes and risks.

Like the Greeks of the classical times, I know I don’t know anything! I have no qualms accepting that the odds are stacked against me and it's very unlikely that I will be the one whose portfolio will beat the general market.

I turned to equity mutual funds. After investing in them for nearly a decade, I stopped. No, I didn't stop investing in equity. Nor have I started picking individual stocks. I don't read "research" reports from brokerage firms. I don't watch CNBC and such TV channels. Nor do I lend ear to stock tips, internet message boards, newspaper/magazine recommendations and hearsays. The odds of anyone (including the financial "experts") beating the general market over a long period is low. Some fund manager may beat the market. But how do we know in advance who that will be?

To remove the risks of lagging the market risks - the most sensible thing to do is to invest in the Index. No stock picking, no churning, and no fund manager. There are a couple of ways we can invest in an Index. Mutual funds and ETFs. I prefer the latter option due to lower recurring costs.

After investing in equity mutual funds over a decade, I have come to the conclusion that it is good for those who would otherwise shun equity, or who would burn money in individual stocks following "tips". For people in these categories, even a low cost ULIP is a better option.But for others like me, Index based ETFs are a much superior option.

These are my gripes against the Mutual fund industry in India:

1. Systemic risk - the chances of a particular fund beating general market over a long time period is low. I don't like the risk of getting stuck with a laggard. (whenever I have mentioned this to my acquaintances, I usually get a response in the lines of "but fund XYZ has given a return better than the general market over 5/10 years!" To this my response is - sure, it has. First of all, how many have done so among all the funds out there? Don't forget to count all the funds which were killed off midway or merged into other funds. Take "survivorship bias" into account. Secondly, how can we know in advance which fund will beat the market over the next 10 years?)

2. Blatant portfolio churning. Mistaking activity for progress is a common human pitfall. We just don't like inactivity. So you see funds with 100% or more portfolio turnover in India. Most of us don't bother to look into this at all. It adds to the risks and costs. We think of such funds as "dynamic".

3. Fund manager turnover. Unlike the US, the "star fund manager" phenomenon isn't big in India. At least so far. But, for what they are worth, there needs to be stability in fund manager just so there's an accountability. If fund managers move from one AMC to another, they have no incentive to generate good returns. Their efforts are geared to increase the AUM (asset under management) so they can get a better remuneration. This is a complete conflict of interest.

4. The blatant quest for AUM is true for AMCs too. New Fund after new Fund is launched with the sole goal of increasing the AUM. There's hardly any real difference among them. It's so predictable. Whatever has taken investors fancy will be the theme of the new funds. And they come in droves. If infrastructure is the "hot" theme, you will see one AMC after another coming up with Infrastructure funds.

5. Distributors - The devils you can't do without. It's a fact that in India investments (as well as Insurance) are sold and not bought. There is a complete lack of education on personal finance aspects among Indians (can't blame us - thanks to half a century of socialism, most of us are new to the concept of personal finance - so far we did whatever option government gave us - it didn't need any education). So we need the distributors. I don't mind paying an entry load to distributors. But the trailing fee is not logical. If I invest now for 10 years (equity investments should have that or longer time frame), I'll pay a trailing commission even after 10 years to someone for a one time service. I don't mind paying an entry load to distributors if they provide me a real service. If all they do is peddle the latest NFO, ULIP, or whatever gives them the most commission, there's a clear conflict of interest. I am willing to pay a commission to someone who is qualified and takes the effort to study my financial situation, my goals and then recommends an investments. All we have now is a bunch of people certified by AMFI (a certification which has been totally gamed by distribution companies). I am NOT willing to pay any commission to such people. Thankfully, we now have the option of buying funds directly from the AMC. We save on the entry load as there is no commission to pay to any distributors. However, the trailing commissions, incentives, foreign holidays for distributors continue to come from the common fund pool. Over a long period of time, these recurring expenses are much more damaging to the fund's return than the initial one time entry load.
Distributors are essential to increase AUM. Fund companies know this and wield to the power of distributors. They pander to them. All innovation in the fund industry in India happens for the distributors' benefit. Most of the times, at the cost of retail investors.

6. Scheming by AMCs. Whenever SEBI comes up with a new rule that will help investors, the AMCs come up with a way to circumvent it. This is a worldwide phenomenon. The regulatory bodies such as SEBI do not pay very high salaries to employees, but AMCs do. So AMCs attract very bright MBAs. So it is quite expected that the AMCs will be one step ahead of the regulators. When SEBI barred charging initial expenses to the fund for open ended funds, each and every AMC came up with close ended funds. The average Indian investor doesn't understand the implication of open ended vs. close ended, he gets fooled easily.

7. Corporate money is pooled with retail money. Due to hunt for AUM, fund companies do not shy away from giving discount on NAVs or other incentives to corporate investors. Alas, this is at the cost of retail investors.

8. High annual expense ratio - It's appalling to see funds with 2+ % annual expense ratios. What justifies this ? In the west, active funds charge around 1%. With a handicap of 2+ % annual expense, the odds of it beating the market are even lower. Even Index mutual funds have 1% expense ratio. What for ?

So far I am happy with Index based ETFs. They have no fund manager risks and much lower annual expense ratio (0.5% or so). I invest in Benchmark's Nifty Bees. There are some other options too. The expense ratio can go lower. Vanguard ETFs in the US have an expense ratio of 0.1%. So we have some way to go, but it's not as horrendous as 2+ % by mutual funds. We cannot eliminate all the risks (what if Benchmark's Nifty Bees does a Satyam on us!). But looking at all the pros and cons, Index based ETFs are the right option for me and not equity mutual funds.


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