MUTUAL FUNDS AND NFOs: METHOD IN MADNESS

Almost every one whom I meet these days asks me for one great “stock tip” which could double in one month. If I was as clairvoyant as that, I could have taken a Premature Retirement and relaxed on a beach in Jamiaca sipping a Pinacolada. I dissuade such friends from investing in stocks, because they are equating stock markets with a gambling den or a race track, where one puts his or her money on a horse or a number and then either loses all or wins big. On such gambles, the probability of losing is extremely high and gaining very poor as defined by the Nobel laureate Kahneman in his Prospect Theory. Very simply put, stock markets are a system to participate in the business growth of a company by being a part owner of that business. The profits are shared between all share holders on a pro-rata basis (infantry officers can understand it too well !!). And stable well-earning businesses do not double their profits every month, thus, stocks which give 100% returns in a month are a rarity and an aberration, just like a guy hitting a jackpot is a one in a million chance.

In the last few months, as my readership has grown, I get a lot of queries on mutual funds (MF). Officers have been getting their portfolios to me for advice. I have been advising them to restructure and shape their MF portfolios. The major issue observed by me was that almost all officers who sought my advice had far too many schemes in which they had invested. Some had as many as twenty schemes. The second problem which all of them had was the NAVs were lesser than their invested price giving them poor returns. Last week I was approached by Mrs Kanchan Khanna, a Veer Nari. She was being hackled by someone in Axis Bank (her bankers) to switch all her existing MF schemes to a new fund offering (NFO) of AXIS 25 Scheme managed by Axis Asset Management Co. She needed a periodic income and had invested in all Dividend Options of her various MF schemes. So far so good. They were all generally good schemes and had been paying a respectable dividend also. After taking two days to analyse all her MF investments and her returns, I advised her to maintain status quo.

Undoubtedly, the best method to participate in stock markets for novices, financially uneducated and inexperienced investors is the mutual fund route. Caveat, have an outlook of minimum ten years. The money grows like a tortoise. Slow and steady. You will certainly beat Defence Services Officers’ Provident Fund(DSOPF) returns hands down. But being greedy as we are (it is a basic human instinct which drives a majority of us), we start looking at the Net Asset Value(NAV) every two to three months. Did you ever look at the DSOPF returns every month?

What is a mutual fund? It is pooling in of money by various people and giving it to a certain Mr Bhoop Singh to invest in stock markets on their behalf. Mr Bhoop Singh is now our Fund Manager. Since, Bhoop Singh may not be known to us and we want some backing of a big name, so a company like HDFC or ICICI hires Bhoop Singh to manage the fund and launches a new fund. HDFC becomes the Asset Management Company(AMC). How does HDFC get people to invest in the mutual fund? It advertises, markets and picks a theme for the new fund. It could launch a new scheme called “Anna Hazare Growth Fund”. The new scheme would be a new fund offer (NFO). And it could have a charter that Anna Hazare Growth Fund would invest only in companies where there is a potential of corruption of 1 lakh crore and above. So, Bhoop Singh will start researching for companies which meet that criteria, telecom companies, coal companies, arms manufacturers , waqf land etc.

The NFO issues new units at Rs 10/- per unit. The first mistake that investors make is, they equate NFOs with initial public offerings (IPO) of stocks. They are as different as chalk from cheese. The MF will deduct the advertising, marketing and distribution expenses from your Rs 10/-. Then, Bhoop Singh’s salary will also be paid by you plus the brokerage on the shares purchased/sold by the fund. By the way, you also pay Rs150 per Rs10000 to the agent or person ‘advising/motivating’ you to make a switch or apply in the NFO. These days all banks have given instructions to their staff to garner subscriptions for various schemes, Mutual funds, fixed deposits etc from their customers. Nothing wrong in it. But since they get incentives on it, they end up trying to give you poor advice. Mrs Khanna faced the same situation in her bank.

For a typical new open ended fund, the recurring expenses could be 2.5% for the first 100 crores of assets, 2.25% for the next 300 crores, 2% for the next 300 crores, and then 1.75% for the balance. So, a fund which garners about 700 crores can easily spend upto 8.5% or 85 paise from your NAV at the start point. You thus, have a starting NAV of Rs 9.15/- for each unit bought for Rs 10/-. Funny, you have to earn a return of approx 10% to just reach your purchase price. This process is called amortization of expenses. And MF AMCs take advantage of it. Thus, most of the people who apply in NFOs have difficulty in initial years and the NAV of their units would be below the purchase price. QED.

What should we do?
Step 1. Stop applying for NFOs. Your agent/advisor would encourage you into investing in NFOs because his/her commission is maximum in NFOs.

Step2. Find a good fund which has least expense ratio and has given a good return compared to its benchmark in the last 5 years or ten years.

Step 3. Instead of paying Rs50000/- for 5000 units @ 10 in an NFO ‘X’, it may be a better idea to buy 1000 units of an established fund like Quantum Long Term Equity with NAV of Rs 25/-. You would be investing in a fund where initial expenses have been amortized and the returns should be similar or more. A gain of 20% in both from start point would result in an NAV of Rs 9.15+1.83=10.18 in the first NFO and your 50000 would be Rs 54900/- whereas in the second fund , it would be Rs (25+5)x2000=Rs 60,000/-.

The second problem is of too many funds in the portfolio. As I had written earlier and has been proven by empirical data to back up, only about 15% of MFs give a return greater than the index. And within that band of 15%, the returns vary between 0.5 to 1%. Why does it happen that way? The answer is simple, the returns are based on two things – the stocks the fund owns and the expenses it makes annually. Almost all MFs have the same top holdings, only their number of shares of a particular company vary. HDFC Balanced may have 50 crores invested in Reliance whereas IDFC Premier Equity may have 70 crores in Reliance. I picked up one scheme each of a diversified equity fund from ten different AMCs and found that the stocks held by them were similar. Only the proportion was different – Reliance, Infosys/TCS/HCL, SBI/ICICI/HDFC Bank, Tata Motors/Maruti Suzuki/Bajaj Auto/Hero Motor, ITC/P&G/Asian Paints, L&T/BHEL/Crompton Greaves. So how can results be different? Some fund managers hold on to more cash or are lucky to take advantage of low prices and give a little better return.

Hence, the optimal solution may be to pick one or two funds/schemes of reputed AMCs. Start an auto pilot systematic investment plan(SIP). Keep the SIP going for at least ten years on a monthly basis. Do not look at where the index or Mr Market is. And have the discipline and patience to reap the rewards after that period. If you have to compare, compare performances over at least one bear and one bull cycle. For example March 2006 to Mar 2012 could give you an idea of what kind of returns to expect. An SIP of Rs 5000/- per month would have taken Rs 3,65000/- from your pocket and would be worth Rs 5,60,000/- or so, giving you a CAGR or XIRR of 14% or thereabouts. Do not get swayed by one year returns of schemes, they are part of the marketing gimmicks because they always give a rider in the end, “MF returns are subject to market risks and the performance may or may not be repeated in future”.

Some of the better schemes which I have researched are HDFC Balanced(G); Quantum Long Term Equity (G); IDFC Premier Equity Plan A(G). Pick any one of those and leave your money for the long haul. Quantum MF looks the best as its distribution costs are very less. It is the only direct to customer MF and can be bought only through their web site/offices. The turnover is very less implying the fund manager does not sell stocks within six months or an year and is a long term investor. The expense ratio is least and the fund size is manageable approx Rs 100 cr as on date. It should give you consistently above sensex returns in the long run.

Tail Piece. The other day while I was warming up at the No 1 Tee at the golf course,  Vikram Varma of the HCC asked me, “Please tell us what stocks you own and we would also replicate?”  I  have no problems in sharing my portfolio. I own only five businesses – Crompton & Greaves, HEG, Noida Toll Bridge, Andhra Bank and Piramal Healthcare. All of them have been bought with an outlook of 5 years and beyond. Also, I now invest regularly in two MF SIPs ie Quantum Long Term Equity (G) and QNifty (an ETF). Only caveat, you do not know the prices at what I bought them and the prices at what I would sell them, which my dear Vikram may make all the difference between your returns and mine. Because remember, stock markets have only two variables –- price and value, rest all is a circus.