By Srikanth Meenakshi
Starting January 1, 2013, mutual fund investors in India will be able to invest in the so-called "direct plans" of mutual fund schemes. These plans will be available when a person invests directly in a mutual fund company, without going through an advisor or an investment service.
The benefit will be that these plans will charge a lower expense ratio compared with the regular plans. Although the actual quantum of difference is not known at this time, speculation is that it would be between half a percent to one percent for equity funds, and less than half a percent for debt and liquid funds.
Should investors opt for these plans? Over the long run, will they stand to gain from choosing this method of investments? What will be the implications of doing so? To answer these questions, it is necessary to look at some current facts and analyse them logically.
Importance of choosing good funds
The universe of investible funds is large - just in the equity funds space, there are upwards of 200 funds to choose from. Including debt funds, the total set of funds available for investments is upwards of 1,500. A regular investor needs not more than 7-10 funds in their portfolio even if they are investing for multiple time-frames, financial goals etc.
Given this, the danger of choosing a wrong fund is more dire than choosing a more cost-effective "mode" of investing. Looking at data, we can see that over the past periods of investments, there are significant gulfs between the best and the worst performing funds.
For a 10-year period, the gap is 23 percent per year! For a five-year period, it is more than 28 percent (see images below)! In fact, an investor over the last five years, would have lost money significantly with imprudent choices rather than making a reasonable, if relatively low, returns.
Obviously, in this situation, choosing good funds makes a bigger impact than cost savings of a few fractions of a percentage point. But does advice really make a difference enabling investors to choose good funds? To try and answer this question, again, we turned to data.
Value of advice
It is not as if this avenue of investment has been newly made available to investors. They have always had the option of investing directly with the mutual fund companies without the help of any investment service. There is even a mutual fund company - Quantum AMC - that gets most of its inflows directly from investors.
However, as per current industry statistics, only a very small fraction of investments come through in this direct route. Even if one looks at only retail investments that are predominantly in equity funds, less than 7-8% of the assets under management have come directly from the investors to the mutual fund schemes.
We were curious to see if there is a correlation between getting advice and investing in good schemes. Although one cannot get exact statistics on the performance of advised investments versus direct investments, we found a couple of data points that strongly support the hypothesis that a majority of investors today have done well with their investments.
If one looks at the five-year performance of all diversified equity funds, there have been 163 funds in this period. Of these 117, or 65% have beaten their respective benchmarks. However, the total AUM of these 65% of funds is significantly more than 65% of the AUM that is spread out among all the 163 funds. In fact, it is as high as 91%!
If one looks at the same figures for a three-year time frame, the numbers are similar - 74% of the funds that have beaten the benchmark's performance have 90% of the total AUM.
Though it does not prove it, this strongly suggests that retail investors today, who are overwhelmingly investing through advisory services, have done well with respect to their investment choices. They have invested in funds that have performed well rather than in lesser funds by a significant margin.
Can Investors do it themselves?
This leads us to the third question. Is choosing funds that hard? Can the investors make these choices themselves? On this question, it is tough to find hard statistics to answer this question one way or the other. However, going by anecdotal evidence and experience, I would be inclined to answer the question in the negative.
However, there has always been a segment of customers who have done their "own research" and seek to validate their choices with us. What we have observed is for the most part, their choices have been influenced in the following manner:
1) Choosing funds guided by recent performances - this by far the most observed mistake - choosing the flavour of the month. Be it pharma funds or FMCG funds or, more often these days, gold funds, the choices of investors often tend to be the ones that have yielded the best performance over the past year.
2) Choosing funds with scant attention to the time frame of their investments - many investors have short-term financial goals of the one-year, two-year variety and choose all-equity fund portfolios.
3) Choosing funds while influenced by friends, media. Having heard about an investment fund that gave great returns, choosing it to try and replicate the same performance.
4) Choosing incorrect investment amounts. Sadly, literacy of financial arithmetic is woefully inadequate among regular investors. This causes them to either define their investment time period or amount required incorrectly, making for an inadequate or inefficient investment portfolio.
With these investors, most of the advisory time is spent on disabusing them their current notions rather than helping them with what they should actually be doing.
Of course, there are a handful of investors who have done a great deal of due diligence and come up with stellar portfolios with great funds that suit their time-frame and financial goals. They even figure out the financial arithmetic required to calculate how much to invest and for how long.
So, the next question, for these investors, is direct a better choice?
Keeping up with changes
Even if an investor has a good handle on how much to invest, how long to invest, and where to invest, it might not be a good idea to invest directly by themselves. The reason is that investing is not a one-time fire-and-forget exercise. True, mutual fund portfolios are low-maintenance efforts, but they are not zero-maintenance. One does need to, periodically, ensure a few things about their portfolios:
1) Is the asset allocation balance in place? Over a period of time equity:debt:gold allocations get skewed and re-balancing periodically is known to enhance the risk-adjusted returns of portfolios.
2) Are the funds still performing well? Do they still merit a place? Even if one goes by popular fund ratings, these are mostly empirical and subject to monthly changes. While an investor was taking care of their career and family, did the fund in their portfolio change from gold to coal?
3) Have there been fund manager changes that we should know about? Recently, there was a significant shake-up with fund houses and a major fund manager moved from one fund house to another. How will such moves impact a portfolio? Would an investor have even known about such changes?
4) Will the folios keep up with an investor - new bank accounts, new addresses, new nominees etc? It is imperative to keep the folios up to date in terms of these details, and often investors miss out on these due to oversight or lethargy.
Typical investors lead busy lives and have a lot on their plates - an increasingly busy work schedule, a growing family, ageing parents, and many more. On the other hand, their investment portfolios are growing larger and require more tending. These two arcs will only diverge over the long-term of an investment portfolio - less and less time available to manage a portfolio that is getting larger.
Come January 2013, investors are likely to get a lot of messages - both from the media as well as from their saviour friends - about the "cost-savings" that they can benefit from the new SEBI regulations. They should be wary of such words. The people giving these "savings tips" are unlikely to help investors choose the right schemes for their specific needs, and are far less likely to be around to maintain the investments and follow-up on their advices.
A direct investor needs three things - be savvy with financial arithmetic, be fully conversant with the range of mutual fund products available in the market, and must have the time to manage their portfolios over the long-term. If one or more of these criteria are not met, choosing to invest directly with AMCs without the help of investment advisory services would be a classic case of being "penny-wise, pound-foolish".
Srikanth Meenakshi is Director, FundsIndia.com, an online mutual funds portal
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Updated Date: Dec 20, 2014 20:27:10 IST