Best Mutual Funds? Good Luck Finding Them!
Everyone is looking to invest in the best mutual funds. And why not! It’s your hard earned money. Best mutual funds or the best investment options – that is the question.
‘Best Mutual Funds – Good Luck Finding Them!’ is the latest in the series of articles in ‘Share market basics for new investors’. This series is written to explain the basic fundamentals of the share market. In these articles, we talk about the “street smart” knowledge investors need to be successful.
Prior articles in this series are Diversification can be a trap, Investing is not gambling, and 4-reasons to build a stock portfolio.
I am not a mind reader, but my guess is that you clicked here looking for answers to two main questions:
Q: Are mutual funds a good investment? And
Q: Which ones should I pick?
The sad fact is that the vast majority of mutual funds under perform the average return of the stock market. Some simply pick bad stocks. Others pick stocks fairly well, but not well enough to compensate for the costs of the fund. Remember, fund shareholders have to reduce their returns by whatever costs are imposed by their funds.
In addition to fees, there are four other pitfalls mutual fund investors have to watch out for:
Management Challenges. Given how many funds there are, not everyone can be above average. Many mutual fund managers have proven no better at picking stocks than the average nonprofessional, but charge fees as though they are. The fees are charged not based on performance but based on the amount invested.
It’s like a 100 m sprint where the bigger is better not the fastest!
No control. Unlike picking your own individual stocks, a mutual fund puts you in the passenger seat of somebody else’s car. If the time comes to sell, you will end up selling the winners as well as the losers at the same time.
Dilution / Over Diversification. When mutual funds own too many holdings, even insanely great performance by their best ideas gets watered down when you look at their overall performance.
Mutual funds are ideal investments for the following types of investors –
- Investors not wanting to invest on their own.
- Investors not willing to learn to invest.
- Investors who are new, and would like to get started.
- Investors having a small amount to invest.
My investing in mutual funds, you pretty much give control to someone else. Like everything else, the moment you give up control, you now have to rely on others to make critical investment decisions for you.
If most mutual funds really did well, why has no one in the world offered the following products?
- Mutual funds where the annual maintenance cost (AMC) is based on the performance.
- Mutual funds where the gains and losses are shared by the fund house. Say, if the fund gains 10%, AMC would be 1%. If the gain is 20%, AMC would be 1.5% etc.
In both these products, the fund manager’s interest aligns with your.
Do high net worth individuals (HNIs) invest in mutual funds? No. HNIs invest in hedge funds. The ways most hedge funds are compensated are as follows –
- Fixed cost – say 1-2% of the investment amount. The investors pay this regardless of the performance of the fund.
- Variable cost – This can be say 20% of the profit if the fund beat the benchmark index by 20% or more. This one is based on the performance. Hence the fund managers’ objectives are tied closely to yours.
In my book, ‘Stock Picking Made Easy’, you will find a simple strategy to identify great companies at reasonable valuations in the Indian Stock Exchange. Identifying great companies at the right time is the key to long term wealth creation.